May 1st, 2023
Financial news, and news in general, tends to lean negative. It seems there’s always something to worry about. Yet, there have been quite a few heavy topics to carry the last few year – the pandemic, the war in Ukraine, the inflation spiral – and now financial pundits have found their next disaster du jour: the debt ceiling.
Every few years it seems we find ourselves in this same narrative. Republicans say wasteful spending is too much and cuts are required. Democrats say Republicans are holding the country ransom and want to cut Social Security and Medicare. This party line debate emerges which is fueled more by its quality as a political fund-raising tool than for a means of advancing society.
That said, as this political theater likely continues up until the midnight hour, and normally we would be dismissive of it, as the US has never defaulted on its debt despite several close calls. However, the market does appear to be taking this debt ceiling debate a little more seriously, as evidenced by a steep divergence in the yield of 1-Month versus 3-Month Treasuries.
Typically, the yields on 1 and 3-month Treasury Bills are quite similar, due to their comparable duration risk. However, the 1-month yield fell swiftly on April 20th while the 3-month yield was relatively unchanged. The reason is that investors are pricing in the potential for a US government default or possibly a credit rating downgrade and paying a premium for the shorter-term debt which will mature prior to the June deadline. While this outcome remains very unlikely, the fact that the yield spread between the two maturities widened to 1.72% is representative of the bond market’s discomfort this time around.
Moreover, Republican House Speaker Kevin McCarthy is not opposed to raising the debt ceiling but is pushing for concessions such as reduced non-defense federal spending and stricter requirements for federal safety net programs. Given that McCarthy’s internal support is tenuous at best – as it did require 15 voting sessions for his own party to confirm him as House Speaker – he will likely be under intense pressure from his party to hold the line and get something out of the negotiations. The internal power struggle within the Republican party muddies the water and adds another layer of uncertainty to the debt ceiling showdown, hence the risk premia increase being demanded for bonds maturing after June.
What are the possible outcomes?
The most likely remains an 11th hour deal to either increase the debt ceiling or temporarily suspend it. The debt ceiling has been suspended seven times since 2013, so depending on public feedback and polling results, both parties may elect to kick the can down the road yet again. If Congress decides to raise the limit, there are still risks, mostly to the US credit rating. Given that there is virtually no upside to triggering a default, it remains an extreme outlier outcome and not something most sane members of Congress would ultimately consider.
The good news is that the debt ceiling fiasco is unlikely to weigh too heavily on equity markets, which have largely ignored the issue thus far. Having seen these debates happen time and time again, it feels like yet another boy who cried wolf scenario…
The bad news is that we likely must endure another month or so of political grandstanding, mudslinging, and embellishment before our elected officials reach an agreement. Until then, it is best to keep the manufactured crisis of the debt ceiling at the back of our mind and remain focused on the more pressing issues for stocks and the economy, namely: earnings and inflation.
And now, your Monthly Market & Economic Update by the numbers.
Interested in learning more? Schedule a call with me HERE.
Warmly,
Mark S Sauer
Market Update
Global Equities: Stocks had a difficult month but overwhelmingly positive earnings led to a late-month reversal. The S&P 500 finished up 1.23%, the Nasdaq gained 0.14%, and the Dow Jones Industrial Average was the big winner closing up 2.48%. Developed International gained 2.63% while Emerging Markets were -0.17% lower for the month.
Economic Update
Housing Deflation on the Horizon? Shelter has been one of the biggest drivers of core inflation at an 8.2% annual rate, but anecdotal evidence suggests we should see a reversal by the second half of the year, if not sooner. Home sales declined in March, an ominous sign for the spring selling season. Existing home sales were down -2.4% for the month and -22% year on year as higher mortgage rates have homeowners sitting tight and buyers reluctant to lock in. Aside from an unexpected uptick in February, home sales have declined in 13 of the previous 14 months. Home prices have fallen for two consecutive months, the first such occurrence in 11 years.
Charts of the Month
Real GDP
Our First Chart of the Month shows Quarterly Real GDP, which grew at an annual rate of 1.1% in the first quarter. GDP was negative in the first two quarters of 2022, prompting concerns that the US had fallen into a recession, but a reversal to end the year restored some optimism that the Fed could pull off a “soft landing”. GDP has weakened for the last two quarters, however, without major improvements on the inflation front. The Fed rate hikes have pushed regional banks to the brink, so we may see them halt rate hikes after May, with little to show for it as inflation remains more than double their 2% target. Stagflation is the new concern if the Fed runs out of ammunition, inflation persists, and growth stagnates.
Bank Performance VS S&P
Our next chart is the SPDR S&P Regional Banking ETF, KBE (blue line), year-to-date performance vs the S&P 500 (orange line). KBE was crushed by the regional bank failures of Silicon Valley Bank and Signature Bank, causing significant underperformance compared to the S&P 500 which has been trending up solidly since mid-March.
Deposits were down for most regional lenders over the last quarter, as the Silicon Valley Bank failure led to an exodus of deposits from smaller banks which then flowed to the mega-cap financial institutions. Regional banks are now directly in the crosshairs of politicians who are looking to reinstate stricter regulations which were rolled back in the past few years.
Nasdaq
Our final chart is a weekly look at the Nasdaq. The Nasdaq lost over -30% in value last year and has a lot of ground to make up. It’s consolidation through the month of April (purple box) above the 12,828 line (green line) indicates that the tech heavy index may be headed for some health gains – and, perhaps, a return back to its market highs. Likewise, a break below the box, and below the 12,828 line would bring the index back into a contraction. Much of it’s direction in the coming months will hinge on the debt ceiling negotiations, as well as continued improvement of inflation data.
