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Inflation and Fed rate hikes have dominated every business and markets news outlet, podcast, or conversation for more than a year now. It’s exhausting and if I had a dollar for every time I’ve heard someone say “Data Dependent” well, I still wouldn’t be able to pay the 50% increase in rent they slapped onto our Miami apartment from 2022 to 2023. However, the debt ceiling has come busting in like the Kool-Aid Man.
I’ve seen countless articles that go into scrupulous detail without taking a step back to lay the groundwork on what exactly the debt ceiling is and how we got here. Well, the best analogy I’ve heard so far is that the debt ceiling is like a kidney stone, we all know it will pass but it’s a matter of how painful it will be. The President and Congress have either increased or temporarily extended the debt limit over 100 times since WWII and under every president in the last 60 years, never allowing the US to default.
What’s a Debt Ceiling?
The US typically spends more money than it can generate in revenue. Let’s not be quick to judge, we all know friends, family or a spouse who act the same way. My wife is an angel, but I trip over a new Amazon package every day. In any regard, this is how a deficit is created. In order to chip away at the deficit, the US Treasury basically takes loans out by issuing T-Bills and other government securities to investors, in essence, raising the money it needs to cover. So where does the ceiling come into play? The Treasury has a limit on the amount it is allowed to borrow which is imposed by Congress. When a new spending limit is authorized, it doesn’t automatically increase the debt ceiling and once the ceiling is reached, new debt won’t be issued unless Congress votes to raise the ceiling again. Ideally, measures would be taken to either decrease spending or increase revenue but raising the limit has routinely been the play.
What are the Consequences?
I want to be clear that the consequences below are like what you see in any medication commercial. The expectations are that the pills work but the rare side effects may include constipation, skin rash, diarrhea, dizziness, etc.
The Government Stops Paying their Bills
If new treasuries can’t be sold to cover costs, the government can’t pay their bills, and the ramifications are grim. Social Security would not be paid as well as veterans, military, law enforcement, national defense, food and safety. Maybe workers come to work and maybe they don’t. Unlikely, but these are fears.
Credit Downgrade
If negotiations don’t go smoothly as deadlines rapidly approach, then the risk of credit downgrades emerges. Credit downgrades could mean higher interest rates. Why? Because investors require higher interest if the risk of holding debt increases. Higher interest rates tend to slow growth in the economy because business owners and two-legged individuals would think twice before borrowing in order to grow their business or buy a home/car as rates simply become too high.
De-Dollarization
This topic has come up a lot by clients and prospects. Frankly, it’s just as likely my wife stops shopping on Amazon as it is that the dollar gets dethroned. A US Treasury default would greatly disrupt global markets and it would increase the fears and headline risks that other currencies, like the Chinese Yuan, would see increased usage. And yes, since 2001 the Dollar has gone from 73 to 58% of the global reserves. However, Russia is settling trades in Yuan because the US threw them out of the global financial markets. If countries don’t lose their minds and launch horrific war campaigns against their neighbors, they don’t bear the risk of getting thrown out of the financial system. You play stupid games and you get stupid prizes. Also, Brazil has upped their usage as well and the Yuan has passed the Euro to become the second most important currency in Brazil. Even at number 2, the Yuan makes up roughly 5% of Brazil’s foreign reserve while the US dollar accounts for 80%. I don’t fault Brazil, my wife and her beautiful family are Brazilian and I take Portuguese lessons twice a week. The truth is, China is the main buyer of iron, soybeans, meat and sugar from Brazil and that accounts for the incremental uptick in total foreign reserves.
Markets decide who the dominant currency is and dethroning the dollar is a tall task when liquidity, accessibility and legal structure are far superior.
Where We Stand with Debt-Ceiling Negotiations
Thursday, Speaker of the House Kevin McCarthy expressed optimism that a deal would get done. Markets liked that. Friday, the Republican team walked out of the meeting an hour after it began stating that the Democrats were unreasonable. You guessed it, the market reacted poorly. The concessions each side is requesting from the other seem to be causing conflict. This is nothing new as negotiations on the debt ceiling are rarely quick and smooth. The Republicans are asking for significant spending cuts and Democrats are pushing Biden to invoke the 14th amendment where a clause essentially gives Biden leverage to avoid cuts and “prohibits questioning of the federal debt.” Sounds like something created in the mid 1800’s…….because it was. More work will be done over the weekend to get closer to an agreement.
Portfolio Positioning
Let’s start off with the facts. As I’m writing, the S&P 500, which is market cap weighted, is at a 9-month high and up +9% on the year. The S&P 500 equal weighted index is up 1% on the year. Why the dispersion? Because the 6 stocks below account for almost all the gains. Only 3 of the 11 sectors (Tech, Discretionary & Services) have returns greater than +1.5% this year.
It feels like we are at an inflection point. Food and services prices are still high as demand persists but Home Depot saw a decline in sales as demand for home goods and improvement have pulled back. The Fed has expressed the potential for a pause in rate hikes as the funds rate is now 5.25% but I wouldn’t rule out a potential hike in July and I certainly don’t think that there will be a cut in the near future. Cuts would put us right back in the same spot we were in a year ago. We are also at full employment. When will this change?
Growth has slowed and forecasts are even worse for the rest of 2023 but earnings in Q1 surprised to the upside. You must also factor in that valuations are historically high in just about every capitalization and style in US equities. There is a genuine possibility of a pending recession. At least that’s what indicators point to.
Economists were forecasting that China would come out of Covid lockdowns with a vengeance and add to global growth but instead the MSCI China index is down -1.5% this year.
With all these diverging factors, how do we invest? A 60/40 portfolio doesn’t always work. We saw this on full display in 2020. It is critical to control what you can as well as position yourself in an “All Weather” allocation. It also must be the right “All Weather” allocation. If it rains, an umbrella may do the job but if it’s a tropical storm you’ll need rain boots and a poncho to go with your umbrella.
Here is the million-dollar question regarding putting new cash to work, “are you willing to invest in something that could see a 10% increase but could also see a 20% pullback if the alternative is investing in cash/treasuries/fixed income yielding 5%?” Is the juice worth the squeeze? An underweight to equities is OK! Owning Treasuries and high grade corporate and municipal bonds offers a solid place to hide when the yield is north of 5%. Also, we can’t stress enough the use of alternatives. We have a full suite of best-in-class alternative investments that are uncorrelated to the broader market. Private markets and directional bets may not only dampen volatility but also provide positive returns in a down market. Structured Notes can fill holes in portfolios as well.
Disclosures
This information is provided for informational purposes only and does not contain investment advice or an offer or recommendation of securities. Connectus Wealth, LLC d/b/a Connectus Private is an SEC registered investment adviser. Investment does not imply government endorsement or that the adviser has attained a level of skill or training.