Macro Monthly: Navigating the US debt drama

Highlights

Negotiations are likely to conclude with a last-minute deal to raise the debt ceiling that increases fiscal drag starting in October, in our view.
We believe a US government default on Treasury debt obligations is very unlikely even in the event that Congress fails to raise the debt ceiling; these payments would likely be prioritized.
Market volatility is poised to rise in the near term as we approach the June 1 ’X-date.’
Given earnings and economic resilience, global stocks may become more attractive if left-tail risks on the debt ceiling fail to materialize.

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As negotiations over raising the US debt ceiling twist and turn, we have three core convictions on their evolution and endgame. The risk of a default on US Treasury obligations is extremely low. A compromise agreement by early June is more likely than not. But volatility is poised to increase in the near term, as markets are likely to price in some risk of a disruptive outcome between now and then.

Discussions had taken a positive turn in mid-May as US President Joe Biden expressed a willingness for deficit reduction via spending cuts and the group of negotiators slimmed to key Republicans and the White House. However, both sides are incentivized to drag out talks to make a deal appear difficult to demonstrate to their respective camps that they negotiated for the best outcome possible. The situation will remain fluid, but we expect more negative headlines than positive ones until such time that a resolution is at hand.

Once left-tail risks linked to a failure to raise the debt ceiling are behind us, we will be back to a world in which economic activity and earnings are likely to remain more resilient than many expect.

Down to the wire

In our view, a deal is unlikely to be reached until just before or shortly after the June 1 ’X-date’ (when the US government is in danger of completely running out of money) as identified by Treasury Secretary Janet Yellen. It has become more likely that, before the government receives tax payments on June 15, the US federal government will be unable to meet all of its spending commitments within roughly a week of the X-date. It is also possible that Congress passes a short-term extension to raise the debt limit and provide more time to negotiate, and we find ourselves replaying this situation in several weeks.

We believe there is a basic framework for a deal taking shape. The most important component is likely to be a multi-year cap on the level and/or growth rate of federal government discretionary spending beginning this October in exchange for lifting the debt ceiling through the 2024 US elections. Reclaiming unspent COVID-19 relief funds from states and energy infrastructure permitting reforms are also likely to be part of any deal.

Reductions in spending relative to the prior baseline will amount to a drag on growth, but one that is surmountable for an economy that is still displaying nominal strength. Any fiscal drag is likely to be less negative for economic activity compared to the fiscal consolidation that resulted from the 2011 debt ceiling agreement.

What happens past the X-date?

Should Democrats and Republicans fail to reach an agreement past the X-date, there are larger downside risks to growth. The US government would immediately need to limit spending to its revenue-generating capabilities. Conscious that a default on Treasury obligations would risk a financial calamity, we strongly expect the Treasury would prioritize making principal and interest payments on the debt over other obligations. Indeed, Federal Open Market Committee (FOMC) conference call transcripts from prior debt ceiling episodes in 2011 and 2013 state that this was the gameplan.

A prioritization of debt payments means that other obligations would not be met. The ensuing drop-off in spending and substantial hit to consumer confidence would be an increasingly negative drag on economic activity the longer the standoff lasts. In our view, any potential period in which the US government is unable to meet all of its obligations is likely to be short-lived. Whether due to market angst or public outcry, lawmakers would feel pressure to reach a compromise.

A failure to raise the debt ceiling, even without a sovereign default, would be negative for risk assets and positive for longer-term US government bonds given the hit to economic growth. The impact on the US dollar would likely be bifurcated, with weakness against traditional safe havens like the Japanese yen, but stronger against growth sensitive currencies.

What if there is a default on Treasuries?

We think there are very low odds that the US government defaults on one of its debt obligations. In the very unlikely event that were to arise, risks to the financial system would be significant. The most severe financial distress occurs not when assets that are known to be risky suffer, but rather when assets that are widely believed to be safe fail. It is very likely that the negative ramifications are not possible to fully identify ex ante, but may include ratings downgrades of the United States, forced selling of US Treasuries, faults in funding markets and broader systemic stress.

In our view, it is more likely that President Biden acts unilaterally to continue paying the US’s debt obligations (citing the 14th Amendment, which states “the validity of the public debt … shall not be questioned”) than it is that the Treasury ceases making principal or interest payments. This maneuver would be drastic and legally dubious, but put Republicans in the optically unfavorable position of trying to get the courts to enforce a US default.

In a worst-case scenario, we are operating under the principle that the Federal Reserve is prepared to act decisively to maintain market functioning should the creditworthiness of Treasuries be thrust into question. Financial stability considerations will be paramount, even though monetary policymakers do not want to be seen as shielding Congress from the consequences of failing to raise the debt ceiling.

The transcript of the 2013 Federal Reserve meeting on the debt ceiling, indicates that then Governor, now Chair Jerome Powell is willing to accept “loathsome” options such as buying defaulted US Treasury securities or swapping unblemished Treasury securities on the Fed’s balance sheet for defaulted ones, if necessary.

Asset allocation

We believe the macroeconomic landscape will become more supportive of risk once this large potential headwind is behind us, and believe a deal will be struck by early June. Any meaningful pullbacks in the stock market linked to concerns about whether a debt ceiling agreement will be reached or if the US government will not service its debt obligations may be an attractive point to increase equity exposure, in our view.

Corporations have retained pricing power amid a slowing in economic growth – and nominal activity is still high and has room to decelerate further without triggering recession fears. The aggregate amount that US companies exceeded expectations increased for both the top and bottom lines during the most recent reporting period. The resilience of nominal activity and margins suggest that downside to earnings is limited outside of recession, which we do not believe is imminent. Core inflationary pressures are also poised to decelerate, in our view, and may give scope for the Federal Reserve to not only skip hiking rates at its June meeting, but go on a more extended pause.

Ahead of debt ceiling talks, our relative value positioning in equities and foreign exchange became somewhat more defensive, in line with our belief that there will be some unease in markets along the way to an eventual deal. We are prepared to be nimble to take advantage of opportunities that arise across asset classes if debt ceiling headlines drive market dislocations in the days to come.

Asset class attractiveness (ACA)

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of 23 May 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the ACA does not include all asset classes, the net overall signal may be somewhat negative or positive.

A chart showing the views of our Asset Allocation team on asset class attractiveness.

Source: �۶��Ƶ Asset Management Investment Solutions Macro Asset Allocation Strategy team as of May 23, 2023. Views are provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

The chart shows the views of our Asset Allocation team on overall asset class attractiveness as of 23 May 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit.

Asset Class	Asset Class	Overall/ relative signal	Overall/ relative signal	�۶��Ƶ Asset Management’s viewpoint	�۶��Ƶ Asset Management’s viewpoint
Asset Class	Global Equities	Overall/ relative signal	Light Red	�۶��Ƶ Asset Management’s viewpoint	In our view, the risk-reward proposition for global equities at an index level is not particularly attractive, but is becoming more positive. Stocks remain expensive, but we believe earnings estimates will remain resilient as tight labor markets support consumer spending while profit margins remain relatively elevated. Importantly, US stocks still account for nearly 60% of global equities, and are particularly richly valued. Risks to global activity are higher following banking stress in March and the possibility of a disorderly failure to raise the US debt ceiling, and the distribution of possible outcomes has widened. Our relative value sector positioning has become somewhat more defensive, as we anticipate some market angst over whether or not Congress will raise the debt ceiling in a timely manner.
Asset Class	US Equities	Overall/ relative signal	Light Red	�۶��Ƶ Asset Management’s viewpoint	US stocks have been relatively expensive for a long time, and would likely underperform more cyclical ex-US equities if global activity proves to be more resilient than consensus anticipates, which is our base case. Earnings estimates for S&P 500 companies are being revised higher once again, and the lower US dollar should help boost profits for multinational corporations.
Asset Class	Ex-US Developed Market Equities	Overall/ relative signal	Light Grey	�۶��Ƶ Asset Management’s viewpoint	Non-US developed market equities are attractively valued but also highly cyclical. There is a lot of variation between DM equity markets based on differing domestic policy stances and degrees of vulnerability to external headwinds. Widespread improvements in shareholder return programs have increased the appeal of Japanese equities. However, we have high conviction that the yen will appreciate, which somewhat diminishes the attractiveness of Japanese stocks in local currency terms. Many forward looking indicators for European equities continue to improve. However, the ECB is committed to bringing policy rates well into restrictive territory, which should limit how much valuations can improve or how strongly Europe’s economy can rebound.��
Asset Class	Emerging Markets Equities (ex. China)	Overall/ relative signal	Light Green	�۶��Ƶ Asset Management’s viewpoint	While China’s reopening is primarily a story of recovering domestic consumption, we believe it will still produce positive, but measured, spillovers for its trading partners as well as mobility-sensitive commodities. Broadly speaking, EM equities have both de-rated and have seen a larger total drawdown in earnings estimates than DM equities. This limits the scope for relative underperformance versus global equities going forward, in our view.
Asset Class	China Equities	Overall/ relative signal	Light Green	�۶��Ƶ Asset Management’s viewpoint	Chinese policy has moved in a pro-growth direction with the abandonment of zero-COVID-19 measures, more support for the property sector, and the end of the regulatory campaign against internet platform companies. These shifts bolster our conviction that economic activity and earnings will improve from 2022 to 2023. However, additional policy support for industrial activity and the housing market may be needed to sustain China’s growth momentum, which has recently flagged. We are closely monitoring geopolitical tensions between the US and China, particularly related to the latter’s relationship with Russia, as these carry left-tail risks to both operating performance and valuations.
Asset Class	Global Duration	Overall/ relative signal	Light Grey	�۶��Ƶ Asset Management’s viewpoint	Long-term bond yields should be volatile and rangebound as robust labor market data and resilient economies square up against the fact that central bank tightening cycles are well advanced and economic activity is poised to decelerate amid tightening access to credit. Central banks’ commitment to keeping policy in restrictive territory and reluctance to reverse course amid above-target inflation should keep yield curves relatively flat until a contraction in economic activity is at hand.
Asset Class	US Bonds	Overall/ relative signal	Light Grey	�۶��Ƶ Asset Management’s viewpoint	US Treasuries remain the world’s preeminent safe haven asset. The Federal Reserve has essentially reached a sufficiently restrictive policy stance, and plans to keep policy quite tight until services sector inflation, which is linked to the labor market, decelerates meaningfully. Stress in the financial sector means we have probably seen the peak in terminal rate expectations for this cycle. The enduring strength of the domestic jobs market is the critical US-centric upside risk to yields. The lack of softening across many labor market metrics despite aggressive tightening may keep the Fed on track to keep interest rates higher for longer, or possibly deliver additional tightening in the months ahead.
Asset Class	Ex-US DM Bonds	Overall/ relative signal	Light Red	�۶��Ƶ Asset Management’s viewpoint	The European Central Bank is drawing a distinction between tools it can use to bring inflation lower (rate hikes) versus other tools that can be employed to safeguard the financial system, if necessary. Elevated inflation, robust wage growth, and improving sentiment and activity data support the case for the monetary tightening campaign to continue in June. The Bank of England has acknowledged that policy tightening to date is unlikely to meaningfully derail the expansion, and that risks to inflation are to the upside. However, the BOE is still somewhat reluctant to deliver too much more policy tightening despite high wage growth and inflation, which is raising the probability that inflation expectations move structurally higher. The Bank of Japan’s expansion of its yield curve control range is a meaningful step towards a monetary tightening campaign, in our view. We believe the new governor is likely to adjust policy further in light of strong wage growth.
Asset Class	US IG Corporate Debt	Overall/ relative signal	Light Green	�۶��Ƶ Asset Management’s viewpoint	We believe shorter-maturity IG debt is particularly attractive given the flat corporate curve and substantial income opportunity. This is consistent with our view that while risks to growth have risen, the economy will remain resilient in the near term.
Asset Class	US HY Corporate Debt	Overall/ relative signal	Light Red	�۶��Ƶ Asset Management’s viewpoint	High yield spreads have widened materially from their mid-2021 lows, but not enough to compensate for increased recession risks following this episode of banking sector stress. The end of the Fed tightening cycle, which appears to be within view, is typically negative for spreads.
Asset Class	Emerging Markets Debt US dollar Local currency	Overall/ relative signal	Light Green Light Grey	�۶��Ƶ Asset Management’s viewpoint	We have a positive view on emerging market dollar-denominated bonds due to the carry opportunity, falling interest rate volatility, and low default rates. A more positive carry backdrop for EM local bonds following rate hikes delivered well before developed-market central banks has increased the resilience of this asset class even in the face of aggressive global tightening. Asian credit is not particularly appealing as valuations are roughly fair and risks related to China’s property market are still elevated.
Asset Class	China Sovereign	Overall/ relative signal	Light Grey	�۶��Ƶ Asset Management’s viewpoint	Chinese bonds have been moving from a high yielder among major economies to a low yielder, diminishing the attractiveness of government bonds somewhat. However, the appeal of Chinese government bonds is bolstered by their defensive characteristics, which are not shared by much of the EM universe, as well as their low beta to global bond indices.
Asset Class	Currency	Overall/ relative signal	��	�۶��Ƶ Asset Management’s viewpoint	We have transitioned to an environment in which the USD is rangebound to lower, in our view. As the Fed approaches the end of its tightening cycle and China’s growth rebounds, the overvalued dollar should depreciate. The main threat to short US dollar positioning is a global recession stemming from banking market stress or a disorderly debt ceiling outcome, neither of which is our base case. The Japanese yen is our most preferred currency given cheap valuations, BoJ tightening, and hedging properties. Some EMFX, like the Mexican peso, are poised to outperform select G10 FX like the Chinese yuan or New Zealand dollar given attractive carry.