Daily Comment (May 18, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with an update on the U.S. debt-ceiling discussion and an explanation as to why it may not be as bullish as some investors would expect. Next, we explain why calls for a Fed interest rate cut in September may be a bit premature. Finally, we end with our thoughts about how global fracturing may improve relations between governments and corporations.

The Debt Ceiling: Market sentiment was lifted on Thursday after President Biden reassured investors that the government would not default on its debts.

  • President Joe Biden and House Speaker Kevin McCarthy announced that the two would meet to discuss the debt ceiling. Negotiations are expected to occur and include the potential for a deal on Sunday after President Biden returns from his trip to Japan. Talks between the two leaders will focus on possible budget cuts as the Republican party aims to reduce the deficit through spending decreases and Democrats look to increase government revenue. The two sides remain far apart on a potential agreement, but after weeks of posturing, there is now progress.
  • Markets welcomed the announcement; however, there are still concerns about whether the two sides can reach an agreement by the June 1 deadline. On Wednesday, the S&P 500 closed 1.2% higher than the previous day, while the tech-heavy NASDAQ finished the day up 1.3%. The improvement in stocks is related to investors’ confidence that the U.S. government will avoid breaching the debt limit and triggering an unprecedented default. That said, government data released Monday showed that the Treasury’s cash balance fell below $100 billion, suggesting lawmakers are less than a month away from hitting the government’s spending cap.

  (Source: Haver Analytics, CIM)

  • A lift in the cap will potentially lead to a knee-jerk reaction in the market, but we would not expect it to last. Over the last few weeks, policymakers have used the cash pile in the Treasury Government Account to keep the government afloat during the debt-ceiling showdown. Research from Strategas shows that the TGA spending has offset much of the impact of quantitative tightening, leading to an overall increase in net liquidity within the financial system. If the two sides agree by Monday, it may lead to a temporary bounce; however, the lack of cash injection would make it difficult for the market to sustain any rally.

Fed Speak: Policymakers have left the door open for an additional hike despite signs that the economy may be slowing.

  • Despite investor expectations, it is unclear whether the Fed will cut rates during a recession. JP Morgan Asset Management stated that it supports the market view that the Fed will cut as soon as September. The remarks reflect previous Fed reactions to recessions where it cut aggressively to protect the labor market. However, this time may be different. As the chart above shows, aggressive interest rate increases have done little to reduce demand-driven price pressures. As a result, we suspect that the Fed may decide to keep rates higher for longer before it chooses to pivot. This scenario raises the likelihood of a prolonged recession.

Global Repositioning: State involvement in industry is becoming more prevalent as countries prepare to move into blocs.

   (Source: Reuters)

  • The fragmentation into global blocs will likely bring government and state interests closer. This dynamic will lead to greater cooperation between lawmakers and businesses that look to prioritize national strategic aims over wealth accumulation. A similar situation occurred during WWI when households loaded up on government bonds to show patriotism. Additionally, firms had friendlier relations with their workers during those times of war in order to maintain positive national sentiment. As a result, we suspect that firms that have close ties with the U.S. strategic aims like defense and aerospace should make suitable long-term investments.

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