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Georgia Senate runoffs: What risks the markets will focus on if democrats win

Yahoo Finance’s Julie Hyman, Brian Sozzi, and Myles Udland discuss 2021 market outlook with Ironsides Macroeconomics Managing Partner, Barry Knapp.

Video Transcript

MYLES UDLAND: Let's talk a bit more about the impact that this stimulus package might have on the economy as we head into 2021. Joining us now for that conversation is Barry Knapp. He is managing partner over at Ironsides Macroeconomics. Barry, always good to speak with you. Thanks for joining this morning. Let's start on the stimulus and if this is something you expected you'd eventually get through, if it changes how you're thinking about next year at all. It certainly helps to have consumer balance sheets shored up, and we saw how much of a benefit that gave the economy through the summer and into the fall.

BARRY KNAPP: Yes. We expected this to happen almost from the day after the election. We had been expecting no fiscal deal until 2021, but once we got the election result, which we did, which basically implies we're going to get a split government-- the Senate will likely stay Republican, although we should come back to that point a little bit because President Trump does appear to have damaged the Republican chances a little bit. But we thought we would get a deal in the lame duck session, and that deal would, in essence, extend those unemployment benefits into 2021, through the first part of 2021. So that was our expectation.

For us, the main outcome or thing that changes around all this is because of what we described in our note this week titled Fiscal Follies. It does appear that the Republicans chances have been damaged somewhat in Georgia. Betting markets dropped by 5%. They were solidly in the Republican camp. Call it 71% to 29% that the Republicans would hold the Senate. But that five-point hit is not insignificant, and that, to us, is the major risk.

Between now and at least the point when the Fed starts to normalize policy or slow the rate of change, presumably sometime in the second quarter or so, we didn't think there was scope for a significant correction of 10% or so. But were the Democrats to pull off a shock victory on January 5, the risk of tax hikes goes up considerably, and we would not be shocked by a 10% pullback in the S&P. So you know, last week was not a great week for the outlook for the market from our perspective.

JULIE HYMAN: At the same time, Barry-- Hey, it's Julie. At the same time, doesn't the risk of more stimulus go up, or the chance of more stimulus go up if indeed the Democrats pull off that win? I mean, even if there were to be tax increases, one would have to think that they're not coming for quite some time given the state of the economy and the fact that we're still on pretty fragile footing. So couldn't you envision a scenario where you actually get the more positive effects of that? And if you're going to get the negative effects for the market that is tax hikes, it wouldn't be quite a ways down the road?

BARRY KNAPP: Julie, we could call that the Goldman Sachs thesis, right? Because that was, in essence, their argument-- that you'd get a lot of stimulus now and you wouldn't get tax hikes till later on. My issue with that is what could very well happen and most likely would happen is something along the lines of the American Recovery and Reinvestment Act back in 2009, where you get no Republican support for another fiscal stimulus plan, which means you need to use reconciliation. The Democrats would need to use reconciliation to pass it.

Reconciliation would imply that it needs to be paid for. The way to pay for it is to pull those tax hikes forward. And so if we get that scenario and they have to pull the tax hikes forward to pay for additional stimulus, then you have to think about the multiplier effects of government spending relative to the negative effects of tax hikes. And from our perspective, government spending is always less efficacious-- that's like the word of the year, right, efficacy-- but they're always less efficacious than the negative impact of hiking taxes.

And so that's the scenario that we're concerned about is that the Republicans don't support any additional stimulus. The Democrats push that too far. Then they have to pull the tax hikes forward. And so that's the risk that we think the market could focus on and could cause a 10% pullback.

That's not our official forecast. We do think the Republicans are going to hold the Senate. We're going to have mixed government. We actually think that's a very good outcome. We're not in the this is a negative scenario. We think we've probably done enough for now to extend the unemployment benefits out through into April, and that will be sufficient to bridge us through the vaccine, and the economy will come back just fine. Just like back in August, we were not worried about going off the fiscal cliff, and it really didn't have any negative economic impact when we did go off the fiscal cliff. So we do think that the outlook is good. I'm just a little concerned that what happened last week will cause this scenario that increases the risk of tax hikes.

BRIAN SOZZI: Barry, you're looking for double-digit equity returns in 2021. Is that off the table if the Democrats do win in Georgia?

BARRY KNAPP: No. Listen, the main factors here I think are very much in place. That is we're going to get a very strong recovery in global manufacturing. We are getting a very strong recovery in global manufacturing and trade, not just because of the pandemic, but because of the 19-month trade war that took place before that. We had the only period since China was integrated into global supply chains where global trade growth was negative when world GDP was positive.

So you could see it even last night in the Vietnamese export numbers, which were so strong. It was the first number we got for December. That's going to persist and be a big positive impulse at the beginning of the year. We think we're going to get a really robust recovery in capital spending. That could be somewhat impaired were my tax scenario to come to play and that corporate tax rate to get hiked significantly, but we still think the argument is for a very strong period of capital spending.

And the reflation story is intact as well. This was not the same kind of disinflationary financial sector shock as the global financial crisis was. And so inflation is headed higher. Eventually that will be a negative for markets, but in the early stages, reflation is a positive. So those forces we think are going to persist and will push markets higher even if we have a policy shock sooner than we would have expected. So you know, our concern is we get a policy shock related to the Fed sometime around midyear. We could get an earlier one if the Democrats taking both seats in the Republican Senate comes to pass. I still think, though, that's a lower probability.

MYLES UDLAND: Barry, just finally, you know, the title of your newsletter, It's Never Different This Time, right? But I think the lack of a financial crisis thesis you were just kind of outlining really struck me in your note, because this is so different than what we saw coming out of 2008-2009. And when you talk about policy shock, is it a risk that all of a sudden in 2022 we're thinking about a Fed rate hike? Is it some kind of big election event? And that's only two years away, right, the mid-cycle re-up. How are you thinking about that?

BARRY KNAPP: Yeah. It's never different this time, but that doesn't pertain just to the last business cycle, as you correctly point out. And so when Reinhart and Rogoff released their book, and Carmen and Vince Reinhart released an abridged version of that in 2010, they talked about how financial crises-- the most persistent economic effect is a decade of disinflation. This was not a financial crisis, right?

So the inflation outlook-- the argument for higher inflation from a monetary perspective is pretty compelling, from a cyclical perspective is compelling. And if you think about where the disinflationary pressures come from over the last three decades, it's come as a consequence of China and the Soviet bloc being integrated into the industrialized world and putting downward pressure on goods prices.

We're now likely to go from just-in-time supply chain management to just-in-case, right? And so you won't see that same persistent disinflationary effect on goods prices. So inflation is headed higher, and I think that's going to make for some uncomfortable moments at FOMC meetings as soon as midyear, where we're starting to push through their inflation target. For now, when they're looking at inflation breakevens rise to 2%, they're patting themselves on the back saying, gee, we're finally winning. But I think there will be a point even this year where they start to get a little bit uneasy with the outlook for inflation starting to increase. And so it is going to be a very different business cycle than the last one, not different than all cycles, but different than the new normal 2009 to 2014 period.

MYLES UDLAND: All right. Barry Knapp with Ironsides Macroeconomics. Barry, always great to get your thoughts. Thanks so much for joining the show this morning.

BARRY KNAPP: Thanks. Thanks for having me.