Authors: Global Investment Strategy Team, Weiheng Chen, Madison Faller
Cross Asset Market Update
It was a relatively quiet week for markets, with just a few catalysts on the macro front. In China, April economic activity data surprised to the downside, with some big misses. Industrial production grew 5.6% year-on-year (vs. 10.9% expected) and retail sales grew 18% year-on-year (vs. 22% expected). Even though the growth figures seem healthy in growth terms, these are off a lower base since this time last year China started its rolling Covid-related lockdowns. To put these numbers into context - averaging across the two years, retail sales growth in April was about 3%, and in industrial production grew 1%. It appears growth momentum is slowing, with increasing divergences between various sectors in the economy. In the U.S., April retail sales figures were solid, with the control group growing 0.7% month-on-month. Yields grinded up over the week on still-resilient economic data, while equities staged a small rally on some positive news flows around the U.S. debt ceiling, which has been a key driver of market sentiment.
At the start of 2023 the U.S. government hit its legal $31.4 trillion debt limit. Over the last few months the Treasury has been using “extraordinary measures” to help the government continue paying its obligations and avoid default. But those measures can only last so long. We’re just less than two weeks away from the estimated June 1st X-date (the day the government can no longer pay its bills) , according to Treasury Secretary Yellen, and President Biden and House Speaker McCarthy will continue negotiations this week. From the outside looking in it’s hard to know how much negotiation progress has been made, but negotiations appear to be heading in the right direction. Both sides have ruled out default as an option and noted progress in the latest discussions. While debt ceiling brinkmanship isn’t new, markets appear to be especially concerned this time, due to the extent of polarization in U.S. politics, and the uncertain U.S. macro environment. From here, we outline three broad scenarios for how this could potentially play out.
Strategy Question: What are the possible scenarios for the U.S. debt ceiling?
Some form of a cap on government debt has been in place since 1917, and debt ceiling brinkmanship is far from uncommon. But if the Treasury fails to make payments on its obligations (the worst case of a default), the impact on the economy and markets could be calamitous, which is a reason to expect that a compromise among policymakers should eventually be found.
A recent history of the U.S. debt ceiling
2011 debt ceiling drama weighed on risk assets
Returns during 2011 debt ceiling episode (resolution = August 2, 2011)
Scenario 1: The debt ceiling is raised or suspended ahead of the X-date
This is our base case scenario. Since the debt ceiling was created in 1917, this has always been the eventual outcome, given policymakers have raised or suspended the ceiling over a hundred times. This time, both Democrats and Republicans have been pretty adamant that a deal needs to raise the debt ceiling, rather than temporarily suspend it (only to have to revisit it a few months later). The main obstacle to achieving a deal currently comes from lawmakers who seek to attach spending cuts to the debt limit negotiations. Speaker McCarthy has called for reducing spending on most programs, with the exceptions of Social Security, Medicare, and the military. Meanwhile, the White House and Democrats have generally pushed back against cuts and instead want to raise taxes. The result is a gridlock that is difficult to resolve.
As news continues to trickle in, we are likely to see investors avoid Treasury bills that mature in the wake of the X-date. This dynamic has already started to play out with dispersion between bills maturing around and after the X-date. We expect these dynamics to continue as policymakers work out the details of the deal – and attempt to reassure investors of the soundness of short-term government debt.
Investment implications: Like in prior instances of debt ceiling drama, volatility can be acute, but it also tends to be short-lived. For many investors, the best defense may be to stick to core portfolios and position defensively. That said, investors may want to avoid T-bills maturing around the X-date, and extend them well past the summer.
The risk of a default is causing Yields to diverge
Treasury bill yield, %
Scenario 2: Go through the X-date – a technical default
We believe there is a small probability of this scenario, even though it has never happened before. There are a few courses of action the government could take to avoid this. The most likely path in this case would probably see the Treasury prioritize payments on debt obligations to creditors (even if they are late) at the expense of discretionary spending such as education and transportation. Secretary Yellen has publicly pushed back on this outcome. The consequence of this is a direct hit to economic activity and financial market sentiment. Even so, determining who gets paid first is a difficult (and very political) task. In all, this would probably end up looking a lot like a government shutdown.
A few other, but more unlikely paths, have also been touted. One could see the Biden administration invoke the 14th Amendment, which has a clause stating that “the validity of the public debt of the United States … shall not be questioned.” In other words, the Treasury could ignore the debt limit and keep paying the government’s bills. Another far-fetched scenario could see the government mint a “coin” to deposit at the Fed, using the funds to pay the bills without raising the ceiling. Both approaches would likely be challenged in court. All of these paths would probably be accompanied by a government credit downgrade, impacting both economic growth and markets.
Investment implications: We would avoid money market funds that only buy Treasuries, which would be most directly caught in the crosshairs. While there would certainly be knock-on effects across the board (such as wider credit spreads), we would prioritize liquidity funds that have access to the Fed’s reverse repo facility, bank certificates of deposit, or corporate credit (in that order of priority).
Scenario 3: Go through the X-date – an actual default
An actual default means the government never pays its coupon or principal back to its creditors. This worst case outcome has never happened, and we assign a near 0% probability to this scenario. It is difficult to detail what constitutes a default or bankruptcy proceedings for Treasuries, but it is likely that the expected harsh reaction across financial assets would warrant movement from Congress. At some point, debt payments would have to resume, with an eventual increase in the debt limit, and the fallout would likely lead to further government credit downgrades. But even if the debt limit is subsequently raised, questions would remain on whether Treasuries would need to trade with a permanently increased risk premium, meaning that investors would demand to be compensated more for taking on greater risk. The “risk-free” rate would likely have to go through a fundamental re-evaluation.
Clearly, this would be bad for both the economy and markets. According to Moody’s, even a short debt limit breach could lead to a decline in real GDP, nearly two million lost jobs, and an increase in the unemployment rate to nearly 5%, from its current level of 3.5%.
Investment implications: Hedging would be key under this scenario. Risk assets would get hit the hardest. Gold, structured notes with deep downside protection, and other safe haven currencies like Swiss Franc, Japanese Yen, or Euro may provide some portfolio protection.
Conclusions and implications
The potential for a disorderly debt ceiling episode provides another opportunity for global investors to reconsider their portfolio allocations across asset classes and regions. Bonds still provide compelling income and protection. For the more tactical investor, safe-haven currencies like the Japanese yen and Swiss franc, as well as precious metals such as gold, could provide some protection. For those sitting on excess cash, debt ceiling turbulence could be a good thing to watch for a potential entry point.
All market and economic data as of May 18, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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