Stocks tumbled at the close as political leaders met at the White House to try and move forward a compromise solution that would allow the debt ceiling to be raised. The result, after the close, was pure political theatre. Shakespeare couldn’t have staged it better. All parties expressed optimism as each identified point personnel that would work toward a compromise as President Biden headed for Japan for the G-7 meeting. As part of the compromise, the President agreed to cut his Asian visit short, deleting a stopover in Papua New Guinea. Hollywood couldn’t have scripted it better if it tried!
So, Biden will return next Sunday. Meanwhile the Senate will be in recess. No sense in hanging around Washington when you can prepare for Memorial Day festivities back home! Now, obviously, there is a bit of sarcasm in my remarks, and all sides feel that somehow a rabbit will be pulled out of the hat at the eleventh hour and probably they are right. But this is Congress 2023 with a fair share of kooks on both the right and left which are likely not to be satisfied with anything. In addition, once leadership reaches an agreement, it will take days to write the actual legislation and, hopefully, find a bipartisan center to pass whatever compromise is agreed to.
Even if Congress misses the deadline by a day or two, the likelihood that the government will choose the option to default on the debt rather than defer social security payments or salaries, is hard to fathom. Obviously, deferring payments and salaries carries with it serious political damage, but the consequences of debt default could be both catastrophic and longer lasting. U.S. debt is the foundation of all borrowing. Overnight trading is collateralized by debt. Major companies fund operations with overnight funds tied directly or indirectly to government securities. Add to that derivatives and futures. A true default would create an unholy mess of unknown proportions. Therefore, it won’t happen.
With that said, should we cross the brink, every incumbent, Republican and Democrat, up to the President, will be held accountable. Yet, there are only two minutes between 11:59 and 12:01. If you drive a motorcycle at the edge of a cliff, the odds of falling over the edge can’t be ignored.
Thus, for the next two weeks, markets will rise and fall according to the progress or lack thereof that is made in Washington. As with any Hollywood script, there will be moments of abject despair, and hints of gleeful optimism.
The stock market, at least until 2:30 yesterday, was complacent, hopeful that brinksmanship would end with a solution. Bond markets are less sanguine. Stock markets still believe a soft landing is likely this year. Bond markets scream a recession is imminent. History favors the bond market being right. Equity markets suggest that even if the debt ceiling is reached, any damage will be brief and cause minimal damage. Bond markets are less sure. The key players, political leaders on both sides, are hopeful, but both sides know that they each face opposition within their own parties. Legislative passage will require bipartisan support, something that has been quite elusive for several years. That is what increases the odds against success.
The debt ceiling crisis isn’t the only item on the economic calendar this week. Retail sales numbers reported yesterday for April were hopeful, but individual retailers, reporting results this week, may offer less optimism. First to report yesterday, Home Depot#, had its largest revenue miss versus expectations in over 20 years. Business wasn’t quite as bad as it seemed. Sharply lower lumber prices and all the storms in California had an outsized impact that probably won’t be repeated anytime soon. The company, looking ahead, sees cloudy skies and the likelihood that same store sales will decline meaningfully for the rest of the year. Every retailer has its own set of circumstances. Wal-Mart won’t have to worry about lumber prices. Logically, companies selling essentials (Wal-Mart sales are 60% groceries) should do better in a weakening economy than department stores leaning on apparel sales, or electronic merchants like Best Buy#. We will learn more over the next week.
While the S&P 500 and NASDAQ Composite are solidly higher so far this year, broader averages are barely up. That is in stark contrast to overseas markets where Japan is near a 30-year high while most European markets are close to 52-week highs. Part of that relates to the weakness in recent months in the dollar. Part is recovery from excessive pessimism from the start of the Ukraine war. Whether we face recession or not, U.S. markets are adjusting to slower growth, and lower inflation. Hopefully, the Fed is done or close to done raising interest rates, but a strong May CPI could change that. The other U.S. problem has been weakness within the banking system. Except for the need to fold Credit Suisse into UBS, world banking problems seem to be U.S. specific, at least for now.
The weakness in the dollar expresses itself in many ways. One is the decline in oil prices. The dollar isn’t the only reason for weakness but it is a significant factor. It also contributes to the price weakness in other key metals and food stuffs. In addition, it helps increase GDP growth by making export prices more attractive and import prices more dear.
Clearly, our economic performance is bifurcated today. Travel and leisure remain strong feeding off of the excess largess handed out by government during the pandemic. That excess is waning but hasn’t disappeared. On the other hand, higher interest rates and generally tighter credit conditions are hurting banks as well as businesses reliant on credit. Existing home sales continue to weaken although new home sales appear to have found a plateau. Retail is mixed with the weak components being discretionary spending, electronics and appliances.
The impact of higher rates and tighter credit conditions hasn’t been fully felt. As a result, economic growth is falling and soon should fall into recession. One indicator that has predicted every recession since 1970 is the rate of change in continuing unemployment claims. It started to hook up last September and the level is now 50% higher than it was back then. If the accuracy of that indicator remains true, expect a recession of some severity in the second half of this year.
Markets look ahead. The inverted yield curve and widening spreads suggest bond markets agree, but stocks remain strong. Stock markets rarely bottom before a recession begins. Right now, markets trade at close to 18 times 2023 estimated earnings. Those estimates are virtually flat with 2022. Such forecasts are inconsistent with a recession. Stocks still believe in a soft landing. Both markets can’t be right.
Yesterday, stocks wavered near the close fearful that no progress was being made in Washington. This morning, futures point higher as the post-meeting tone yesterday was mildly positive. All expressed hope that a crisis could be averted. June 1 may not be the actual deadline but it appears reasonable that it won’t be much later. Congress will need all the breathing room it can get to get a bipartisan majority together. Even if the debt ceiling is reached, alternatives like deferred payment of salaries and benefits would be a first step, one that will raise public ire for sure and ignite a fire under the feet of all elected officials to get the job done. Only in government do we see action deferred until crisis arrives.
Post-crisis, the belief of many is that markets will pop in a sigh of relief. That may be true in the very short term. But soon, the focus will return to economic reality. Are 2023 and 2024 earnings estimates realistic? If there is to be a recession, the answer is no. Thus, after an immediate celebration, reality suggests some moderation.
As noted earlier, what’s curious is the relative performance of international markets compared to ours. Europe has coped with the Ukraine/Russia situation much better than expected. Japan’s economy is doing well. No other nation has to deal with a debt ceiling event. Nor are banks overseas in dire straits, at least not at the moment, but perhaps the biggest difference is valuation. Our markets have been more expensive largely because our economy has been leading for over a decade, but without the tailwind of quantitative easing and Congressional largesse, our growth rates are slowing as others are stabilizing. Slow growth isn’t a sin as long as it is sustainable. Moreover, looking at France as an example, we are seeing more rational behavior overseas. France is raising the retirement age and backing away from some overly expensive climate initiatives. At the same time, we play see, hear or speak no evil when it comes to entitlement reform at the same time this administration continues to pivot left. Without making any political statements, economically, many of the steps taken are anti-business. Thus, post-debt ceiling crisis, clouds will remain for some time.
Today, Craig Ferguson is 61. Sugar Ray Leonard turns 67.
James M. Meyer, CFA 610-260-2220