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Investment Strategy Commentary: What's Next?
Since March, our Investment Policy Committee had identified Debt Dislocations as a key risk to watch. With a debt ceiling bill signed and a month’s time since the last bank failure, we now look ahead – over both shorter tactical and longer strategic investment horizons – to determine what has changed (and what has stayed the same).
With the passage of the Fiscal Responsibility Act (FRA), financial markets have removed the left-tail risk of a U.S. default (at least until the debt limit suspension expires in 2025). Per the Congressional Budget Office (CBO), the FRA will reduce the fiscal deficit by ~$1.5 trillion over the next 10 years, mostly via two years of enforceable spending caps (left chart below). Not included in the CBO’s estimate are a handful of off-paper agreements and budgeting gimmicks (“side deals”) that should help mitigate fiscal drag over the next two years (right chart below). Separately, the banking system appears to have found its footing following significant stress in March that extended into May with the fall of First Republic Bank. After over $200 billion in March outflows, small bank deposits were roughly flat in April and positive in May. Moreover, new Fed emergency lending to banks – via discount window borrowing and Bank Term Funding Program lending – has fallen sharply. While the full impacts of credit tightening are likely still on the come, and future stress remains possible, investors have enjoyed a period of relief following the roughly two-month period of heightened bank concern.
While equities are holding on to strong year-to-date gains and investors are pricing in a near-term end to the Fed hike cycle, we face a still-inverted U.S. yield curve, stalling economic growth and stubbornly sticky inflation. And so from these levels – and after all that has transpired this year – we take this opportunity to reflect and ask: What’s next?
POST-DEBT CEILING DEAL NORMALIZATION
Investor concerns related to the debt ceiling were concentrated in fairly narrow portions of the market. U.S. equities were reasonably well-behaved and implied volatility held below longer-term averages, but cautious positioning dominated the front end of the Treasury market. Investors avoided maturities surrounding the date when the Treasury was expected to run out of money, which resulted in elevated yields for T-bill maturities in early-June and dampened yields for T-bill maturities either before or a bit after that expected “X-Date”. Debt ceiling concern also showed up in expectations for future Fed policy, with investors pricing in 1% of cuts by January – which we read as investors expecting few-to-no cuts in the base case while assigning a low probability to a severe outcome. For example (and simply for illustrative purposes), a 25% chance of 4% in rate cuts would show up as an expectation for a 1% cut.
Following passage of the FRA, the portions of the market that showed elevated concern on the debt ceiling have largely normalized. Per the chart below, as of June 5th, Treasury market yields surrounding the X-Date have retreated from the elevated levels seen in the weeks prior to the news of a debt ceiling agreement (May 24 and May 16 being the weeks highlighted in the chart). Investors are now only pricing in one 0.25% Fed cut by January – as investors removed that left-tail risk of the U.S. government, at least temporarily, “defaulting” on its debt and additional time passing since the last bank failure. To wit, spreads on one-year U.S. credit default swaps (a gauge of default risk) have fallen from over 1.75% to just 0.1% today.
When the U.S. reached its borrowing limit on January 19, it invoked extraordinary measures to fund the government up until this past week when the debt ceiling bill was signed into law. In doing so, the Treasury depleted its cash balance with the Fed known as the Treasury General Account (TGA). It now intends to replenish the TGA and there is some concern that this process could drain liquidity and push up yields. We are less worried about this risk as, first and foremost, we believe the Treasury market is sufficiently liquid such that the impact from a rebuilding of the TGA balance should be rather limited. Beyond that, we take solace in the following considerations:
- There’s potential pent-up demand for T-bills with near-term maturities. For instance, money market funds have benefitted from inflows and may be eager to buy the newly issued debt.
- The market had already been pricing in a surge in supply as progress was made toward resolving the debt ceiling issue. Reallocating from the Fed’s overnight reverse repo facility to T-bills should also limit any upward pressure on T-bill yields as new issuance materializes.
- Likewise, any resulting upward pressure on repo rates associated with greater availability of collateral would likely be mitigated by investor shifts from the Fed facility to non-Fed repos.
LONGER-TERM IMPLICATIONS
We start with the longer-term implications as, despite not being immediate concerns, they are perhaps more interesting than the near-term implications (addressed in the following section). In our kickoff meetings for our annual capital market assumptions (CMA) process, the idea of “trust deficits” across the geopolitical arena and financial markets continued to rise to the surface – most prominently with respect to the trust between China and the U.S. (and the broader “West”) and trust in the U.S. dollar as the world’s reserve currency. The latter was not helped by the U.S. government flirting with a default – even if the likely worst outcome was a short-term delay in making those debt payments. Nevertheless, the last couple weeks only added fuel to the growing concern that the U.S. dollar’s status of global reserve currency is coming under threat.
While it is likely the case that the U.S. dollar won’t be able to hold on to reserve currency status forever (as they say, forever is a long time), we don’t see this risk playing out over even a strategic (10-year) investment horizon – much less within our tactical (one-year) outlook. There may be deals to transact outside of U.S. dollars – for example recent discussions between China and Saudi Arabia to price oil barrels in yuan – but transacting in a currency and holding a currency as a store of value are two different things. The latter needs very deep financial markets to ensure sufficient liquidity to buy and sell large volumes without creating market disruption – and, as of right now, the only market and currency in the world that can provide that is the U.S. Treasury market and the U.S. dollar.
While one could argue that the attractiveness of the U.S. dollar has declined on an absolute basis, currencies are a relative game. There is simply no credible alternative to the dollar today or any reasonable time horizon. Over the past 20-plus years the U.S. dollar’s representation in aggregate global central bank holdings has fallen from 71% to 58% (a 13% difference) but no one single currency has reaped the benefits (instead spread out across the euro, the pound and the renminbi – with none seeing more than a 3% gain). At worst, we believe this will continue to be a slow-moving rebalance – likely with a lower limit – for the foreseeable future.
SHORTER-TERM IMPLICATIONS
At the macro level, the debt ceiling deal – and resulting fiscal spending reductions (versus what was previously planned) – should cause a very modest (0.1-0.4%) hit to real economic growth, all else equal. And one could reasonably argue less (often unproductive) government spending is a good thing. Individual sectors and industries – in relation to the broader economy – often can see more acute impacts in these situations. Worth reviewing are the impacts to Energy and Industrials/Defense.
Energy:
The energy portion of the debt ceiling deal has a focus on overhauling the nation’s permitting laws for energy-related infrastructure projects. One of the key headline issues was a requirement for federal agencies to issue the remaining permits for the long-delayed (and hotly contested) ~$6.6 billion and 303-mile long Mountain Valley Pipeline – a natural gas pipeline project running from West Virginia to southern Virginia. Additionally, the bill protects the pipeline’s permit approvals from further legal challenges. This part of the bill angered some, including environmental groups opposed to the pipeline. However, again looking at the big picture, the bill is designed to speed up the process of permitting the buildout of many energy projects including not just hydrocarbon-related projects (pipeline and facilities), but also solar facilities, wind farms, electric transmission lines, EV chargers and other clean energy projects. The bill amends the existing National Environmental Policy Act (and potentially speeds up the process of approving projects) by setting up a single federal agency to handle environmental reviews and sets time limits on key permitting issues such as one year for environmental assessments and two years for environmental impact statements. In addition, there is an emphasis on increasing regional electric power capabilities/capacity and boosting the energy transfer capacity between regions (this is a critical issue underpinning the transition to clean energy fuels). While the bill appears to walk the middle ground and includes items that should please legacy energy (hydrocarbon) and clean energy proponents, we expect the pitched battle between both factions to continue and for future projects to once again get bogged down by legal tussles between the opposing groups.
Industrials/Defense:
The debt ceiling deal will allow for defense spending growth in FY (fiscal year) 2024 of 3% and limit growth in FY 2025 to 1%. Recall, expectations had been for the White House FY 2024 budget request to show 2% growth in defense spending. While growth will clearly slow from the 10% growth in the FY 2023 budget, 3% growth is much better than fears of deep cuts to defense spending as a part of a debt ceiling deal. As a part of the deal, FY 2024 defense spending would rise to $842 billion and it is notable that the traditional link between defense and non-defense discretionary spending is being broken as non-defense discretionary spending is expected to step meaningfully lower in FY 2024 and remain mostly flat in FY 2025. Defense stocks have traded off in excess of the Industrial sector over the six weeks heading into the agreement, likely reflecting concerns of steeper cuts, and current relative valuation is consistent with very modest budget growth. Beyond the 3% growth in the overall defense budget, Ukraine-war-related spending will be requested outside the defense budget in supplemental requests which have not been capped as a part of the debt ceiling deal. Defense outlays as a percent of gross domestic product (GDP) remain near multi-decade lows, supporting our view that defense spending would not see a significant decline. Over longer timeframes, we expect GDP-like growth in defense spending (~1.5-2.5%) with excess growth in response to geopolitical concerns.
NARROW BREADTH” IMPLICATIONS
While Energy and Industrials are the most relevant with respect to the debt ceiling deal, the Technology sector has been most relevant more broadly – with the seven largest names in the S&P 500 (which all happen to be Technology or Technology-adjacent companies) contributing more than all of the S&P 500’s gain this year. We illustrate this below in Exhibit 4.
We believe this exceedingly high concentration of returns in such a narrow portion of the market can be looked at two different ways:
- It represents a vulnerability to the U.S. market because a change in sentiment on a narrow list of companies could have a material impact on broader market performance. This is the more negative point of view.
- It represents a pathway to additional upside potential for stocks, as the average company in the S&P 500 has not experienced the gains visible at the index level, and could begin to participate. This is clearly the more positive point of view.
2022 was a reminder of how sensitive growth stocks can be to interest rates – rising rates are negative for growth stocks as more of the value of a growth company is in the future, making it more sensitive to the discount rate applied to those future cash flows to determine a value today. Interestingly, however, as interest rates have increased over the past several weeks, growth stocks have continued to do well/hold on to gains. Conveniently, the rise in rates was accompanied by the enthusiasm around Artificial Intelligence (AI), which provided an offset to what might have been a more challenging backdrop.
We are of the view that the current valuation of the U.S. market represents a headwind to performance from here, and that participation from the “other 493 names” in the S&P 500 could come via “churn” – where gains in the average stock are funded by trimming back the year-to-date winners – keeping overall market performance more muted from here.
CONCLUSION: OUT OF THE DEBT DISLOCATION WOODS, BUT A HIKE AHEAD
The resolution of the debt ceiling and stabilization of the regional banks have materially reduced the left-tail risk of a systemic shock – and risk assets have repriced higher accordingly. While the recent developments are a relief, we still find ourselves in a situation where economic growth is approaching stall speed and, yet, inflation remains too high. So, while investors are out of the debt dislocation woods, they still face a hike ahead of them. In fact, this is literally so, with a current 90% probability of a Fed rate hike in July – assuming the Fed stays pat at its meeting this week, as is largely expected.
Central bankers globally are walking a monetary tightrope, wherein they must appreciate the balance between price stability and financial stability. The anticipated “stop-start” cadence from the Fed is one example of the uncertainty this monetary tightrope is introducing on a global level. The European Central Bank is likely to continue to raise rates into an already-started German recession. Meanwhile, the People’s Bank of China is attempting to spur demand via small reductions in bank deposit rates just as they continue their efforts to rein in financial speculation that easier monetary policy can exacerbate.
On the economic growth front, the drag from the debt ceiling deal will be modest, with investors likely not overly upset about a modest cut in reputationally wasteful government spending while appreciating the small positives for the energy and industrials (defense) sectors. On the financial market functioning front, the removal of the Debt Dislocations risk case (notably the left tail of that risk case distribution of outcomes) is a clear positive – though one that the markets quickly appreciated and priced in.
Looking ahead, investor attention will remain largely focused on the monetary policy tightrope – and rightly so, as it will be a delicate balance. We expect muted U.S. equity market performance going forward (the “churn” option offered on the previous page) – especially in light of U.S. valuation levels, which look elevated at this point in the economic cycle. In our global policy model, we sit underweight all equity regions – which are all dealing with a slowing global economy that has yet to feel the full impact of monetary policy, especially should more firepower be needed. Within risk assets, we prefer high yield bonds (relatively constructive fundamentals for a near-9% yield while being empirically less risky than equities) and natural resources (also providing relatively constructive fundamentals at valuations well below historical levels as well as potential protection from geopolitical/inflationary risks).
Special thanks to Christian Lambert, Investment Analyst, for research support. We would also like to thank Antulio Bomfim, Head of Global Macro, and Dan LaRocco, Head of U.S. Liquidity, for their insights into the short-end of the yield curve – as well as Jackson Hockley, Senior Energy Analyst, and Mike Towle, Senior Industrials Analyst, for their insights into energy and industrial/defense sector ramifications as a result of the debt ceiling deal.
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