U.S. Debt Stand-off To Add to Volatility

A delay in lifting the U.S. debt limit, as well as the euro area debt crisis, spurred a bout of market volatility in 2011. See the chart. U.S. Treasury bill yields seen as the most vulnerable to late payment jumped, and the S&P 500 fell about 17% between July and August 2011. Policy rates were near zero back then, deflation risks were emerging and the Fed's balance sheet was expanding. All that provided a cushion. The backdrop is very different today. Bond market volatility has already surpassed the 2011 level (dark orange line) as markets grapple with central banks’ trade-off: either live with some inflation or crush economic activity. Equity volatility is more muted (yellow line). Yet we don’t think stocks have been immune – just a few major tech stocks account for almost all S&P 500 returns this year. Our conclusion: Brace for higher volatility because of the combined effect of debt ceiling concerns and financial cracks from rate hikes.

It’s uncertain when exactly the U.S. Treasury will run out of funds to meet its financial obligations – known as the “X date.” Treasury Secretary Janet Yellen has warned that could happen as soon as early June. Conversations about a last-minute deal to raise or suspend the debt ceiling, meaning eliminate it for a brief period, are ongoing as Democrats have so far rebuffed Republicans’ push for spending cuts and other concessions. The Treasury risks a technical default when it temporarily fails to make its bond payments if policymakers don’t strike a deal in time. The Treasury may prioritize paying bondholders over others, but it’s unclear if the Treasury can do so: There is no precedent, and the Treasury lacks the legal authority. Yet there is precedent for credit rating agencies trimming the U.S. top-notch credit rating like S&P did in 2011 – even if a technical default doesn’t happen. That could cause investors to demand more compensation for holding U.S. assets amid higher risk.

Yields for some Treasury bills maturing just after the X date have already started to rise, but risk assets have yet to fully react. Yields for the affected Treasury bills could march higher, and volatility may keep cycling through assets if the debt ceiling is repeatedly suspended.

We stay invested but caution against this backdrop. We had already been going up in quality and focused on building resilient portfolios as the Fed rapidly hiked rates. We see opportunities to earn attractive income in short-term debt if yields rise more. Investors who don’t need to quickly sell assets can earn attractive income during the debt showdown, in our view, by holding on to at-risk Treasury bills until they mature. Persistent inflation makes inflation-linked bonds attractive, too. Notably, demand for gold has picked up via exchange-traded funds and foreign exchange reserve managers.

Developed market equities remain the bulk of portfolio allocations, even as we underweight them slightly in the short term. We prefer emerging market (EM) stocks in the short term as they benefit from China’s economic restart, EM central banks nearing the end of their hiking cycles, and a broadly weaker U.S. dollar. We could consider leaning more into equities overall if debt ceiling volatility and recession create a sharp fall in equity prices.

Bottom line: The debt ceiling showdown is set to increase the volatility in financial markets that has defined the new regime. Any selloff may cause risk assets to better price in the economic damage we expect from interest rate hikes. We’re ready to shift our views on a six- to 12-month horizon to take advantage of opportunities that may appear.

Market backdrop
Global stocks were largely unchanged last week and bond yields stayed within their range since mid-March. U.S. CPI data showed that core services inflation, excluding shelter, is easing, but core goods prices surprisingly ticked higher. Core inflation still doesn’t look on track to settle near the Fed’s 2% target, making Fed rate cuts this year unlikely, in our view. The Bank of England hiked policy rates to 4.5% as it carries on with its fight against stubborn inflation while growth stagnates.

Macro Take

We’re expecting U.S. inflation to settle between 3-4% by the end of 2023. That assumes goods prices will cool as spending shifts back to services and higher interest rates soften the labor market, subduing wage growth.

But last week’s April CPI data showed that core goods prices surged and core services inflation excluding shelter stayed sticky through the last three months. That means annual core inflation is running close to 5% in the three months to April – too high for the Federal Reserve. See the chart.

The one glimmer of hope? Core services inflation excluding shelter did decline in April – but we would need to see that decline extend over a longer period to prove that underlying inflationary pressures are easing.

The persistence of inflation is why we don’t expect the Fed to cut rates in 2023. We think the effects of higher interest rates – amplified by credit tightening due to rate hikes – should ease inflationary pressures later this year.

Investment Themes

1 Pricing in the damage

• Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view.
• That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
• In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers' depleting savings.
• The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve signaled a pause after hiking rates in May. But it also reiterated that persistent inflation means no rate cuts this year. We see the European Central Bank going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
• Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.

2 Rethinking bonds

• Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starved for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
• Very short-term government paper looks more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
• In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
• Investment implication: We prefer very short-term government paper over long-term government bonds.

3 Living with inflation

• High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
• Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower-carbon world.
• Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.

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