For all the fretting about the political standoff over the US debt ceiling, one fund manager sees the deadlock providing a boost to the stock market.
The reason, says Pictet Asset Management’s Steve Donzé: The Treasury, unable to borrow, now has to draw down its bank account at the Federal Reserve to fund itself, pumping liquidity into the financial system. That’s likely to support stock prices until the ceiling is lifted, said the investor, who is deputy head of investment at the $770 billion firm’s Japan unit.
Donzé, who for years has tracked the ebb and flow of global central bank liquidity provision and its interplay with markets, otherwise isn’t a fan of US stocks. In asset-allocation funds that he co-manages, he is underweight, seeing American equities as expensive and vulnerable to tighter Fed monetary policy. Yet his view on the debt ceiling has caused him to increase his allocation.
“The debt ceiling issue is hitting the street and the net effect of this is the exact opposite of what you might expect,” Donzé said in an interview. “We feel still comfortable having less risk in the US, but a better-than-expected liquidity story has allowed us to make some reallocation.”
The view may seem counter-intuitive, given the risk that lawmakers fail to raise the debt limit in time to avert a US default on its debt. Many look back at 2011, the most serious debt ceiling episode of recent years, when stocks slumped in late July amid a political standoff over budget deficits and the debt ceiling. The two sides agreed to raise the limit at the last minute, though S&P stripped the US of its AAA credit rating in the aftermath.
The US Treasury last month began special accounting maneuvers to avoid breaching the limit on the amount it can borrow. Congress now must raise it to allow the government to continue spending and paying its debts, though the Republicans who control the House of Representatives are trying to extract budget cuts from the White House in return for authorizing an increase.
If default actually comes to pass, all bets are off. But most investors remain certain a deal will be reached on time, and as Congress debates, the impact for markets is positive, said Donzé, adding that this year’s 6.1% gain for the S&P 500 is at least partly down to liquidity increases starting in January.
Here is how it works. The Fed is reducing its balance sheet, a process known as quantitative tightening, whereby it does not replace maturing bonds in its portfolio, leaving more paper in the market for other buyers. Currently it is unloading $95 billion a month of bonds, a liquidity drain that amounts to a 2% monthly drag on the S&P 500, according to Donzé’s models.
But as the Treasury resorts to using its bank account at the Fed to fund itself, it releases liquidity into circulation — a $550 billion drawdown of its Treasury General Account by mid-year would boost the S&P 500 by 12%, he calculated, more than canceling out the drag from QT.
That’s because when the government taps the general account, either to repay debt or meet daily expenses, the money flows into commercial banks’ accounts, increasing financial system liquidity. Meanwhile, because the Treasury isn’t borrowing, money-market funds are deprived of the short-term bills they favor, leaving them awash with cash.
A pause in Fed rate hikes after March will add to this year’s liquidity tailwinds, Donzé said. “You will have a rate-rise pause and a QT pause in effect, which is much more benign for asset prices,” he said.
His funds had been sidestepping so-called growth stocks, including technology, given their vulnerability to tighter liquidity, Donzé said, but he now sees an opportunity in US communication services shares, which look cheap relative to the rest of tech.
But despite the increase in allocation and this year’s US equity rally, Donzé said he prefers emerging markets to the US, noting policy-tightening cycles have ended and China’s post-Covid reopening is set to benefit developing economies.
Nor will the Treasury’s cash drawdowns deliver a sharp net liquidity boost. Rather they will relieve pressure on markets by neutralizing Fed QT. And finally, when the ceiling is lifted, the liquidity boost will fizzle as Treasury bond issuance returns. The Fed’s liquidity drain and its negative impact on stocks will resume, Donzé said.
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