Elephant in the Room

The current debt ceiling debate in Congress is a great reminder that investors should always prepare for the unexpected and invest in companies that are durable enough to withstand a range of economic scenarios.

It has been our experience that markets are more volatile when outcomes do not meet investors’ expectations. For example, if investors are expecting the Federal Reserve (Fed) to raise rates by 75 basis points, those who expected the decision would not necessarily see a reason to move the markets, while those that are surprised would likely think the markets were mispriced given the new information. This is a variation of the efficient market hypothesis, but one in which expectations, rather than information, drive what is and is not priced into the markets.

Such moves are most dramatic when the unexpected is not just an unanticipated outcome of a known event but an unforeseen event entirely. Take the Covid-19 pandemic, as well as the global reaction to it. The magnitude of the market reaction was, in our opinion, a direct result of the magnitude of surprise felt by both Wall Street and Main Street, in this case made more extreme when paired with the equally powerful emotion of fear.

As investors and risk managers, we believe a prudent investment process aims not only to identify and quantify the market’s largest known risks but also to think about risks that are less obvious in order to mitigate the impact of both expected and unexpected events. To that end, we think it is worth highlighting the U.S. Congress, which we believe has the potential to impact the economy and the markets to an extent greater than the Fed’s interest rate policy over the next two meetings.

The Fed has not yet had the full impact on inflation and the economy that it has been hoping for. Though it has correctly cited a lag effect to explain when policy changes will manifest themselves in the economy, patience is in short supply among many market participants today. But Congress may be giving Fed Chairman Jay Powell and the U.S. economy an unwelcome push. In December, while the markets were focused on what was ultimately a predictable decision by the Fed to raise interest rates by 0.5%, our focus was on the frantic negotiations taking place in Congress to pass a budget bill by December 23.1 To be clear, there was little risk of a failure to strike a deal and avoid a government shutdown. So why did this capture our attention?