Now that the election is over, both parties should come together to help the American people recover from the damage wrought by the Covid-19 pandemic. Increased federal spending coupled with a Federal Reserve that continues to be highly accommodative are necessary to nurse the U.S. economy back to health. In addition to creating jobs and boosting prosperity, the government’s actions would benefit the stock market, particularly small cap cyclical companies.
Most important, Congress must act to pass a focused stimulus package with policies designed to have multiplier effects on the economy. This means fiscal support for important areas such as infrastructure and broadband build-out as well as targeted tax incentives. The first two would produce jobs and increase economic activity while also making our economy more productive. The targeted tax incentives, which should specifically cover tax credits for the purchase of a home or car, would improve the economy in two of the biggest and highest multiplier impact areas.
Investors tend to overweight the impact government actions can have on stock markets, and the U.S. financial markets have already priced in significant stimulus measures. If their expectation doesn’t become reality, it could have a deleterious effect on the markets and, by extension, the economy overall.
Still, it’s worth bearing in mind that the influence any president can have on the economy and the markets hinges on their ability to enact legislation. So we’ll need to wait and see what Joe Biden can achieve as president, which largely depends on the outcome of two Senate races in Georgia. If Biden can secure a substantial stimulus package, it should cause a near-term rotation into more reflationary assets as well as give a boost to long-neglected small cap value companies.
While a stimulus package would likely cause a sharp risk-on factor rotation into cyclical names, that move could be more robust once the coronavirus vaccines become widely available. The recent news of two highly effective vaccines from Pfizer and Moderna is highly encouraging. As economic activity expands, small cap stocks should outperform their large cap siblings and cyclicals should outperform defensive areas of the market – a long-recognized historical pattern.
How would a stimulus package impact small caps? Being much more domestically oriented than large caps, small cap stocks should feel the effects more quickly and more strongly. When demand improves even slightly and leads to inventory restocking, many small cap companies with strong finances, for example, will enjoy increased pricing power.
As a professional investor, I lean heavily toward cyclical businesses – companies that benefit from a strong economy. They can carry lower risk because they often are inexpensively priced without a recovery, and in sectors where capacity has been removed and end-user inventories are very low.
One headwind is the potential for higher corporate taxes under the Biden administration. Again, due to their greater dependence on the U.S. economy, such increases would have a more meaningful effect on small caps. Nevertheless, the net effect of a generous fiscal stimulus package combined with targeted tax incentives would still favor small cap stocks.
As our economy begins to recover from a deep but short-lived recession, a significant stimulus would likely improve what is already a favorable climate for small cap stocks. Ultimately, what’s good for the U.S. economy should be good for small cap stocks as well.
Charlie Dreifus is a managing director and a portfolio manager with Royce Investment Partners. His analysis above is not intended to be relied on as a forecast of future events or as investment advice and all views are his own.