Telemus Weekly Market Review May 8th - May 12th, 2023
Concerns around the debt ceiling are heating up after Treasury Secretary Janet Yellen sent a letter to congress on May 1st stating she expects the Treasury will no longer be able to satisfy government obligations by early June, and potentially as soon as June 1st (referred to as the X-date). This number was further substantiated by the Congressional Budget Office (CBO), who similarly expects that the Treasury’s X-date to be in early June.
This date has moved up from earlier projections after April tax receipts came in lower than expected. A key contributor to lower tax receipts was fewer capital gain in 2022 given declines in both stock and bond markets. Fewer capital gains resulted in taxpayers having lower tax payments associated with their 2022 tax filings that were due on April 17th. The governments financials are such that payroll tax receipts provide a regular stream of income, while quarterly estimated tax payments make up a more episodic stream of revenue into the Treasury’s coffers. In the context of the current situation, estimated payments that are due on June 15th will help to temporarily shore up the government’s finances. Therefore, if the federal government can make it to June 15th, which appears to be a tight squeeze, then they would likely have enough funds to support their obligations into late July or even August. These nuances around government finances make the debate and timing around a potential government default even more challenging to assess and handicap.
We don’t pretend to be political strategists, nor do we believe we have any insight around whether the government will hit a point of running out of funds and have to default on its obligations. Our hope and expectation is that government will not default on its obligations. However, we are of the mindset of hoping for the best but preparing for the worst. In this light, we wanted to talk through how we are thinking about the reaction of stock and bond markets if such an unprecedented event as a federal government default were to occur.
Bond Market Impact
The most notable security in the crosshairs of a potential default are U.S. Treasuries. In particular, U.S. Treasury bonds maturing at or around the time that the federal government runs out of funds are at risk of not receiving their principal at the time of maturity. There is active debate on whether at that point the Treasury would use any revenue that comes in to prioritize payments to Treasury bond holders. That could happen, but there is no precedent, and the current administration has not discussed any plans for how they might prioritize payments. Should this occur, we would expect that once the debt ceiling is ultimately raised, these bonds would then be paid off, with additional accrued interest being paid on the extra days the bond was outstanding.
The challenge in this scenario is how bond prices would behave. In theory the values on only those Treasury bonds that had matured, but were not paid off, would be impacted. Market expectations would likely be that the debt ceiling debate would be resolved fairly quickly. Even for those bonds that were in default, the expectation that they would eventually be paid off could lead to them holding their value. Treasury bonds with maturities that are a month or more beyond the X-date would seem less likely to have material movements in their price. However, in such a situation the creditworthiness of the U.S. government could be tested and investors, particularly foreign investors, may begin to demand a greater premium on Treasury bonds. Therefore, the variety of considerations adds ambiguity in how to assess the market reaction in a default scenario.
The other issue for the bond market is the impact the default would have on liquidity across the broader bond market. Treasury bonds are held by banks, insurance companies, mutual funds, corporations and individuals. All of whom would be impacted to varying degrees. Such an event would not help confidence in markets of cash and cash equivalent investments. Therefore, we could expect some modest dislocation in prices of cash like instruments. Individuals with outsized cash needs at or around the targeted X-date may be best served by holding some extra cash across diverse funding sources (i.e., physical cash, money market funds, bank deposits).
General bond market liquidity could also be pressured. Thankfully we don’t have a great deal of experience with the federal government nearing default. The most analogous episode was 2011, where the federal government’s X-date was estimated to be August 2nd. Ultimately the debt ceiling was raised on July 31st. Interestingly during this period, bond markets remained calm going into the X-date. However, following the debt ceiling being raised, market jitters resulted in a notable sell off in risk assets. On the bond front, yields on high yield bonds expanded by over two percentage points, fueling a price decline of over 5% for high yield bonds in early August of 2011.
Stock Market Impact
Despite the uncertainty around a nearing June 1st X-date, the stock market appears rather sanguine. This is not atypical considering during both 2011 and more recently the debt ceiling debate of 2021, stock prices were steady even as the X-date loomed. Options markets, which trade off volatility expectations, currently project higher volatility going into June, however, these projections are less than what was expected one month or even three months ago. A key driver of this is many market participants are holding firm in their present portfolio positioning as they await greater clarity on the debt ceiling. We would expect volatility to accelerate as June 1st nears and that for volatility to continue and possibly accelerate following a resolution as investors return to the market and reposition portfolios to reflect any adjustments to expectations.
Experience would indicate both from other events where there is greater uncertainty, as well as the 2011 debt ceiling debate, that higher risk assets are likely to be challenged should the debate drag on. During the 2011 debt ceiling episode, small cap stocks and more economically cyclical companies sold off more than the broader market. What’s interesting from the 2011 escapade is that stocks muddled along up until July 22nd, roughly two weeks before the expected X-date. They sold off modestly going into the X-date but didn’t experience a notable selloff until after the debt ceiling was raised on July 31st. During the week following the raising of the debt ceiling, the S&P 500 fell -7%. Following the market close on Friday August 5th, Standard & Poor’s downgraded the credit rating on the U.S. federal government from AAA to AA+. This led to a further selloff of just under 7% the following Monday, August 8th, with the market effectively bottoming out at that point. From August 9, 2011 through the end of the year, the S&P 500 returned 13.4%, retracing most of its early August decline.
All told from April 4th, 2011, when then Treasury Secretary Timothy Geithner first notified Congress that the federal government had hit the debt ceiling, through the end of 2011, the S&P 500 index had a total return of -4%. It was clearly a volatile ride and those that took a long-term perspective were able to weather the environment.
Telemus Expectations
The rhetoric out of Washington the last couple of weeks would indicate a resolution is unlikely in the coming days or week and that there is a greater probability that a resolution might not occur until closer to the X-date. As this date nears, we expect market volatility to increase, with a greater potential for downside risks to stock prices. While we don’t like uncertainty, we do believe the debt ceiling is an isolated incident and barring a prolonged default, we would view the events as having little to no materiality on the long-term prospects for the U.S. economy or corporate earnings.
Barring anything unusual, we’d expect any dislocation that was solely a function of the debt ceiling to work through the market is fairly short order (a couple of quarters). Despite the S&P 500 being up roughly 7% on the year, market sentiment is generally negative. Many fund managers are sitting on elevated cash positions. Hedge Funds have been reducing their exposures. Moreover, money market fund balances are at elevated levels. The removal of some uncertainty could spark a more optimistic tone and markets could easily rally as money is put to work and portfolios are repositioned. In such a scenario, a shift in market leadership would not be unreasonable and some of the laggards year-to-date may begin to recover while some of the larger and more defensive stocks may become sources of funds.
The prospect of a potential default by the U.S. government on its debt creates unnecessary anxiety and ambiguity. While no one can project with precision how things will unfold, history would indicate its likely to be an isolated incident that is likely of having a reasonable resolution. Maintaining a long-term mindset, ensuring near-term liquidity, and being willing to take advantage of any potential short-term dislocations is the tactic we favor.
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