Stocks rallied late Friday, eliminating most earlier losses to close mixed. Bonds fell but yields stayed within a narrow range. With just over two weeks to go before a possible debt default, most attention will be focused on progress toward raising the debt ceiling. While both sides seem entrenched, behind the scenes talks are taking place. Expectations continue to be that an 11th hour solution will be found. Clearly, there is some room to give on both sides. Hopefully, common ground can be found.
Neither side wants to blink first, at least publicly. Biden wants no conditions to raising the debt ceiling. He isn’t likely to escape that easily. Republicans in the House passed their proposal through the House. Parts make complete sense. Others will be non-starters for the Democrats. There is little sense in my trying to parse what the solution may look like. What matters is that there is one. Even if leaders of both sides agree, any compromise will have to pass both the House and Senate before becoming law. The calendar is clearly tight. President Biden leaves for an overseas trip this week. Hopefully, there will be some signs of progress before he goes.
June 1 is often stated as the deadline. That may or not be true. It is the earliest date that the debt ceiling might be reached but not necessarily a hard date. Nonetheless, negotiators can’t take too many risks that there is any extended period past June 1 to reach a solution.
Unfortunately, we have seen this gambit played out before. Brinksmanship is part of the political process, and there is nothing like a crisis or a pending crisis to spur action. So far, markets have presumed that a solution can be found in time. After all, America has never defaulted on its debt in history. Why now?
That doesn’t mean that at some point Wall Street won’t start to panic. It did the last time things went down to the wire in 2011 and it took a few months to recover. What makes 2023 different is the bifurcation of interests within each political party and the narrowness of the majorities in both chambers of Congress. Even if an agreement were to be reached before Biden leaves for the Far East (unlikely!), Congressional leaders will have to sell the package. Whatever solution is reached will require bipartisan support, at least in the Senate where 60 votes are needed. You can count on the probability that far left and far right members of the Senate will be tough sells. While the House can theoretically pass a compromise package along party lines, Leader McCarthy has had his struggles controlling both edges of his coalition. There are several who insist they will never vote for any increase in the debt ceiling. One can argue the sense of that stance, but logic doesn’t matter. Only the votes count. Thus, winning Congressional approval isn’t something likely to happen overnight. In fact, it isn’t beyond probability that Congress might reject or tweak any initial compromise.
The timing issue alone raises the concern that the debt ceiling will be reached before it is increased. While the White House has yet to spell out its game plan to deal with such an event, the least likely first step is a debt default, largely because the consequences are unknown and could be catastrophic. While all concerned would know that any “default” likely wouldn’t last very long, and the U.S. would ultimately pay its debts in full, the status of the dollar as the world’s reserve currency and the willingness of investors to buy U.S. debt in the future near current price levels is unknown. The last time the debt ceiling was almost reached, S&P lowered the nation’s credit rating. Long term, that didn’t matter. That doesn’t mean next time can’t be different. No one, particularly the President just beginning a campaign for reelection, wants to chance any adverse consequences.
The alternatives to debt default are to cut spending to a point that we stay within the debt ceiling limits. That means some combination of deferred salaries, late payables, or reduced entitlement payments. All are nasty alternatives. All will invoke hardship for incumbents of both parties. Clearly, it won’t take long to get majorities in the House and Senate in line to pass an increase with whatever conditions are necessary to get the job done. Once that happens, the deferrals will be made up and our economic world will return to normal.
While that suggests no long-term consequences, that isn’t necessarily so. If the conclusion proves messier than most now perceive, any incumbent running for reelection, and that includes President Biden, will have to answer for the debacle. One can only imagine what Trump will say if the debt ceiling is violated!
For investors, the short-term key is whether signs of progress appear before Biden leaves this week. One simply can’t flip a switch at 11:59 PM on May 31 to avoid a real mess. Congress probably needs at least a week and that assumes little dissention. May 26 is the Friday before Memorial Day. June 1 is the following Thursday. May 26 is the end of next week. Yes, the 11th hour is near.
Yet, investors so far are assuming catastrophe will be averted. I have no reason to disagree. But how much upside is there if there is an agreement? Sure, stocks will rally a bit, but we still face stubborn inflation and declining growth. One Fed governor last week even suggested yet another rate increase might be necessary in June. The economic picture, even without debt ceiling concerns, isn’t rosy. And stocks aren’t cheap, selling for more than 18x projected 2023 earnings. The downside could be a short swift decline. Thus, even if one expects a successful end to the crisis, near term staying on the sidelines for the moment isn’t a bad idea. We have never crossed the red line toward default before, but we rarely have seen such a politically bifurcated setup as we have right now. Good investing is matching risk versus reward. The odds of a positive outcome are probably well over 50:50. The consequences of a mistake can be serious. To me that is a setup for elevated caution. If there is no apparent progress over the next 2-3 days, I expect markets to start to reflect concern.
It’s a sports day for birthdays today. Andy Murray is 36. Linebacker Ray Lewis is 48. Emmit Smith turns 54. Finally, George Brett is 70.
James M. Meyer, CFA 610-260-2220