Trip Hazards

The U.S. debt ceiling is just one of a long list of obstacles waiting to trip up markets, and there is very little opportunity cost for remaining cautious.

In February, when the Congressional Budget Office (CBO) projected that the U.S. government would run out of money sometime this summer, Joe Amato suggested that investors should consider that just as important as they considered the outlook on inflation and rates.

Joe did not think the U.S. would default on its debt, but he warned that the threshold could still be “a source of volatility over the next three to six months.” Over recent weeks, it has indeed become a top concern for investors, although from our perspective it represents merely one among a number of potential trip hazards they have to choose from.

Despite the increasingly frequent headlines about the risks of hitting the debt ceiling, these concerns do not appear to be making their way into equity markets. Stocks are close to their highs for the year and the CBOE Volatility Index (VIX) is close to its low.

In our view, every time the risks build up and the markets fail to correct, it reinforces the case for caution on risky assets, particularly while high rates on cash and short-dated fixed income mean investors are being “paid to be patient.”

Nervousness

As U.S. tax receipts come in slower than expected, there is growing alarm that the debt ceiling is closing in.

Still, the consensus is that Republicans don’t want to be blamed for the chaos of a default (as evidenced by the bill they passed in the House of Representatives last week), and that Democrats don’t want the issue to be postponed into an election year, and that therefore a last-minute compromise will be reached. Perhaps a calm market is the appropriate response?

We don’t think so. The U.S. didn’t default in 2011, but it got close enough for the S&P 500 Index to lose almost a fifth of its value. If things go to the wire, the government may have to temporarily halt government spending to make interest payments, creating what could be an additional growth shock to an already faltering economy.

Markets aren’t entirely ignoring the risks now: As my colleague Joseph Purtell has observed, the spread between the yields of one-month and three-month Treasury bills has been exceptionally wide and volatile. Similarly, while the VIX is near its 2023 low, the Merrill Lynch Option Volatility Estimate (MOVE, the equivalent of the VIX for bonds) has been bouncing around at historically high levels. It may be only a matter of time before that nervousness spills into equities.

Warning Against Complacency

Another major headline from last week provided a similar warning against complacency.

For more than a month, it seemed that the banking-sector stresses that broke out in March had been contained. The shares of First Republic Bank, perceived to be the most likely next casualty, had stabilized around $14.

But it is earnings season, and First Republic’s disclosure that first-quarter deposit withdrawals were bigger than analysts had estimated halved its share price again, sending a new shockwave through the wider sector.

That, in turn, is likely to raise further concern about leverage levels and financing pressures in certain parts of the U.S. commercial real estate industry, to which the vulnerable regional banking sector has been an outsized lender. This is a segment of the market that we are watching closely.

While there may be no more First Republic-magnitude shocks from this season’s earnings reports, and large-cap technology appears to be holding up well, we have long anticipated that the earnings picture will deteriorate significantly as we move through the year. Those expectations are getting support from weakening economic data (last week revealed a U.S. GDP growth slump in the first quarter), tighter credit conditions, and stubbornly persistent inflation and central bank hawkishness, especially in Europe and the U.K.

Cautious, Liquid and Flexible

This is a long list of obstacles waiting to trip up markets during 2023. It is possible that none causes a major incident. But we think it is probable that at least some of them will significantly slow down progress.

We believe investors can benefit from remaining cautious, liquid and flexible over the coming months, to be ready to take advantage should markets take a fall; and high rates at the front end of yield curves mean there is little opportunity cost to doing so, should things turn out better than expected.