‘Removal of tail risk’ is driving the markets amid impending Biden transition: Ironsides Macroeconomics Managing Partner

Biden's impending transition is sending stocks higher today. Ironsides Macroeconomics Managing Partner Barry Knapp joins Yahoo Finance Live to discuss.

Video Transcript

ZACK GUZMAN: Now, let's break the mood down a little bit more here with our first markets-focused guest of the day. Let's bring in Ironsides Macroeconomics Managing Partner Barry Knapp. And, Barry, I appreciate you taking the time to Chat

You just heard Bryan discussing that kind of initial reaction we got there from the Yellen naming. You pointed out similar points as well, her support for extending unemployment insurance and greater federal transfers to state and local governments. How big of a decision is this for President-elect Biden and where the next administration goes on the economic front?

BARRY KNAPP: Well, I think what's really been driving the markets in recent days and over the last 24 hours, in particular, is the removal of tail risk. And, you know, once we got an election outcome that-- although it's not absolute certainty-- but most likely, the most likely outcome is that there will be a Republican-controlled Senate, which implies that cabinet positions need to be approved by the Republican Senate and be vetted by Mitch McConnell and the Republicans.

And so I think Peggy Noonan-- writes the column in The Wall Street Journal every weekend-- really nailed this before the election, which was this was a good outcome for Joe Biden because it allows Joe to be Joe. So the appointment of Janet Yellen as opposed to some of the more left-leaning candidates or hawkish candidates like Elizabeth Warren, for example, even some of his national security candidates, all are pretty centrist outcomes. The approval of the GSA starting the process, all these things are sort of removing this tail risk and moving us towards a lower volatility, more sane sort of an outcome.

So I think that's the general mood. But there are a couple of ongoing issues, some of which were fully discounted by the market, right? So, if I were to look through all of the possible policy issues related to Chair Yellen that could be a negative for the market, the one that comes to mind, first and foremost, is bank regulatory policy.

So we had very tight bank regulatory policy for the first eight years of the recovery. Return on equity in the banking sector never got above 10%. There was a push to have increasing amounts of bank capital and a big cushion.

The Trump administration loosened all that. ROI went to 12%. The group finally performed well in 2019 after a perennial underperformance. And I was underweighted the entire decade.

We could move back in that same direction. The only mitigating factor to that is the bank sector has been far and away the worst performer this year and is decidedly cheap on all metrics. It's probably the only sector you could call cheap. So I think the banking sector was actually pricing something closer to a Warren outcome than a Yellen outcome.

So, in that sense, the negatives to a Chair Yellen being Treasury Secretary were fully discounted. And, you know, the positives, coordination with the Fed, understanding that we have massive amounts of debt-- by the way, the Fed and Treasury did coordinate activities from World War II through the mid-70s.

So I'm in the inflation camp. But this was inevitable, no matter who was Treasury Secretary. So I think, on balance, the market's accepting this because they'd already resigned themselves to a more hawkish bank regulatory policy environment and a higher inflationary environment. And, by the way, for the first year or so, more inflation is probably a good thing for markets, not a bad thing.

AKIKO FUJITA: Barry, what about the issue of tax policy? You know, there seems to be this expectation that-- what Joe Biden had campaigned on in terms of bringing the corporate tax rate back to 28% and, of course, raising taxes on those making $400,000 are likely not to pass, at least if Republicans succeed in hanging onto those two seats over in Georgia.

I mean, does this appointment or a reported appointment of Janet Yellen really make a difference? I mean, how are you viewing that in light of her likely to be the Treasury Secretary?

BARRY KNAPP: I don't think so. I think it's really in the Democrats interest to do a deal in the lame duck. And that's a very contrarian view right now. In fact, before the election, when I thought the Senate would go along with the presidency, I was assuming that any fiscal stimulus deal that got done would be done in 2021.

But now that you have this split deal, if you think about the Democrats' position on this, if they roll the dice and hope for two victories in the Georgia Senate so they could get everything that Treasury-Secretary-elect or to-be-appointed Chair Yellen would want, they run the risk of not getting any Republican votes whatsoever, even were they to win both of those seats, in which case, they'd have to use reconciliation.

That means it would have to be paid for. And they'd likely have to pull those tax hikes forward along with fiscal stimulus, which I doubt they really want to do the tax policy right now. I suspect, if they do-- they were to get the tax policy at all, it would more likely be a later 2021 event. So I think there is a deal done in the lame duck.

If not done in the lame duck and Republicans do control the Senate, they're not going to be able to push through the full Biden agenda. So I think-- I don't think she's going to have a big role to play with all this, other than, perhaps, putting in her two cents about, yes, she should extend the unemployment insurance-- and I think Republicans are already on board with that-- and, yes, she should have greater transfers to state and local governments.

But, if there's going to be a deal, Republicans are going to have to agree to that, too. So I don't think she's going to have a big role to play in tax policy. You know, trade policy will be far more interesting, right? I mean, where she comes down on China and the tariffs is a big open question. You just haven't heard very much from her on that issue.

ZACK GUZMAN: And, Barry, I mean, the idea of getting a deal through, as you noted, in the lame duck session would be contrary. But you have another contrarian view there as you were talking about inflation. A lot of people seem to be thinking that disinflation is much more likely here.

So talk to me about what the impacts-- or how you see inflation rising, when it might start-- we haven't necessarily seen it in a major way yet-- but also where Janet Yellen's thinking might be on that? As a Fed chair, obviously, inflation is top of mind. As Treasury Secretary, I'm not sure what her view points might be.

BARRY KNAPP: Well, I'll start with your final question, which is all part of the same question. But your final question first, which is, were that, say, 10-year Treasury yield to move from its current level of just under 90 basis points or 9/10 of 1% up to something like 1.3 or 1.4, if that movement is largely attributable to the inflation component of yields and inflation expectations or so-called inflation break evens went to 2 and 1/4% from their current 1 and 3/4%, the Fed would actually be patting themselves on the back, saying, see?

We finally generated inflation, and we pushed through our target. And our new average inflation framework is a good framework, and we're doing the right thing. So they would actually be pleased. And that's why I made the earlier comment about re-inflation would be perceived positively by the markets for the first part of it.

Now, my broader inflation call has monetary and non-monetary elements to it. And I'll try and keep it as succinct as possible. But, on the monetary side, the big difference between this recession, or contraction, and the last one is that the household sectors and financial sectors were at their highest levels of leverage relative to GDP going into the financial crisis.

So, for the first five years of the recovery, that leverage was being drawn down. In fact, for the household sector, it's continued to have been drawn down the whole cycle. So there was no way that, even with creating a whole bunch of cash on bank balance sheets, a big increase in bank reserves, that that money was going to get lent out in the so-called money multiplier, velocity of money was going to increase.

This cycle is completely different as evidenced by the boom in the housing market. And, even today, right, housing prices are exploding higher. And that's because the household sector is not underleveraged, and the financial sector isn't underleveraged.

All the leverage is at the government sector. And the history of leverage being at the government sector is, you know, first, they try and tax their way out of it. And then they try and inflate their way out of it. So that's the monetary argument, and it really is different this cycle versus last one.

But the non-monetary argument is that all the inflation, or disinflation, for the last 30 years has come through goods prices. And that's primarily attributable to China and the Soviet bloc entering into the industrialized world and increasing the global supply of labor to produce those goods by 120% From 750 million workers in '90 to 1.2 billion workers in 2010.

So that starting note to move the other way, we're going to move supply chain management from just-in-time to just-in-case, restructure supply chains. We can't have the kinds of shocks hitting that that hit over the last couple of years, right? First, the trade war and then the COVID pandemic. So I doubt we're going to have disinflation coming from goods prices over the next decade the way we did over the last three.

So, if you take that negative 1%, you make it plus 1%, and service-sector inflation continues to run at 3%, you're through the Fed target of 2% in no time. And so, to me, there's a pretty compelling case that the 2020s are going to be-- you know, it's not going to build right away. It's going to slowly build, and we'll go through 2 next year. And then we'll continue higher up. It's not going to 5 in 2022 or anything. But it's headed higher, in my view.

ZACK GUZMAN: Well, your point on the housing front, well received. We got that S&P Case-Shiller report, showing the biggest spike in six years in terms of home prices. So you're right on that front. We'll keep monitoring it.

But appreciate you joining us today. Barry Knapp, Ironsides Macroeconomic Managing Partner, thanks to again.

BARRY KNAPP: Thank you.