Stocks gave up some ground last week as earnings season got into high gear. This will be the biggest week for earnings. In the bond market, the big news was the emerging huge spread between ultra-short Treasuries (those sure to mature before any debt ceiling default) and 3+ month maturities (those that might get hung up in a short-term default scenario). The message is clearly one of concern that a bifurcated Congress and stubborn administration won’t be able to negotiate a solution before time runs out.
Obviously, I have no better idea than anyone else whether our government will allow us to default on debt payments. Using “extraordinary measures”, the Treasury has pushed back the ultimate date to somewhere between June and September, with July seeming to be the most likely time. The Treasury will make a statement next week, post the April 18 tax payment receipt date, that could move the deadline up or out a bit. Republicans in the House will try to pass a bill that constitutes a wish list for spending cuts. It is meant to be an initial salvo in the debate. So far, the White House hasn’t budged from its position that it won’t negotiate. But it will.
Once the debt ceiling is reached, the government will be precluded from selling more debt to fund operations. Defaulting on bond payments, principal or interest, is one alternative, but not the only one. It could defer paying salaries to workers or members of the military. It could defer making Social Security payments. And it could simply default on its interest or principal payments on debt. All have huge negative consequences. Congress and the White House have gone to the proverbial 11th hour before. The last time, in August 2011, a crisis was averted just hours before the deadline. S&P subsequently lowered the nation’s debt rating, more a symbolic move than one that cost taxpayers any money. Today, there appears to be less common ground between the Conservative Right and the Progressive Left, but both would agree that defaulting on debt is a bad idea.
While earnings season will dominate markets for the next two weeks, it is hard to see markets making big upside moves until the argument is settled. Both sides have their flawed arguments to make. Both sides are wrong in their tactics. Hopefully matters can be settled before nasty consequences occur. But one thing is sure. If the government tells Americans that they won’t be paid or their bonds aren’t good money, the political consequences will be significant and negative. It’s too early to tell which side will get blamed the most, but that is the side that will blink first. Ultimately, all debts and salaries will get paid, but as the short-term Treasury market is already making clear, this skirmish is having negative consequences and there are more to come before the dust settles.
The debt ceiling fight is likely to be the leadoff to the 2024 Presidential election campaign. While many Americans, maybe most, don’t want to see a repeat of Biden vs. Trump, at the moment that appears to be the most likely outcome. Democrats don’t seem to have any viable alternatives while early Republican attempts to rise to the top have stumbled. The Republican winner-take-all primary process strongly favors Trump, while no Democrat as yet seems ready to challenge Biden. Emerging third party talk has begun, but any such effort requires a charismatic leader. So far, none has emerged, but it’s early.
Back to earnings, maybe the most intriguing report will be today, when First Republic Bank reports. After the failures of Silicon Valley and Signature Banks, First Republic has been viewed as the one most at risk of a run and subsequent failure. What management has to say today will go a long way to answering the question whether the recent phase of a credit crunch is winding down or simply hibernating.
Overall, so far earnings haven’t been market moving. The actual results, as always, beat projections. But outlooks have been mixed. The big tech names, those at the top of the S&P 500, report this week. All have been cutting costs. All are seeing revenue deceleration. Has the news been fully discounted in stock prices? We’ll see. I suspect that rather than a monolithic response, as we saw in January, it will likely be more nuanced this time around. Some companies seem better situated than others looking forward. The other message is that cost cutting alone can’t save a company’s value. Ultimately, revenue growth is necessary. For most of the big companies the dual questions are (1) what is the long-term sustainable growth rate, and (2) what are the sustainable profit margins?
When have we seen this movie before? Not long ago, oil companies were spending beyond their means to maximize production and revenue. When investors sent the message that free cash flow growth was more important than production growth, they adjusted and stock prices rose. They rose because ultimately, free cash flow is what drives stock prices in the long run. Look to streaming as another example. Everyone has been chasing Netflix, trying to maximize the number of subscribers. But all, except Netflix, are spewing red ink. The result has been to raise prices and moderate expense growth. Even Netflix is discussing moderating production costs. The end result is still to be determined. After Meta Platforms’# CEO Mark Zuckerberg told Wall Street that he was all in on the metaverse at any costs, investors bolted, sending the stock down to prices not seen in years. Zuckerberg quickly reversed course, got spending religion, and the stock recovered. The other leaders have followed suit in some fashion, adjusting spending down to a new lower growth environment. But funding fewer moonshots is not the same as spending to protect core businesses. Generative AI poses risks to Google’s search engine business, for instance. Tik Tok challenges Facebook and Instagram platforms. Retail is gaining share again against online platforms. We will learn a lot this week.
As earnings season winds down, as the economy slows, and as the debt ceiling debate moves to the front page, stock prices will face significant headwinds. It’s hard to make a case to be overly aggressive now. We have seen this story play out enough times in the past to know that, ultimately, our debt will be secure and this battle will have a happy ending. July and early August 2011 were not fun times for equity investors, but they proved to be good long-term buying opportunities. So, get your buy list ready and refine it from what you learn from the rest of earnings season. By the time the debt crisis reaches its crescendo, the Fed should be done raising rates. That will set a good backdrop for the second half of the year.
Today, Kelly Clarkson is 41. Barbra Streisand is 81. Shirley MacLaine turns 89.
James M. Meyer, CFA 610-260-2220