Financial Update from Brewin Dolphin - 19 May 2023
The Weekly Round-up
Friday 19 May 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the latest US debt ceiling negotiations and lacklustre economic data from China.
The third week of May was a good one for equity investors. In large part this was down to the market climbing the wall of worry that had been built from concerns over the debt ceiling. Bonds eased over the week.
Dancing on the ceiling
The US statutory debt limit, or debt ceiling, is an absolute cap on the amount of debt that the Federal government can take on. Under Article 1 of the US Constitution, Congress must authorise government borrowing. In fact, prior to World War I, the legislature would directly authorise every bond issued. In response to the funding needs of America’s participation in the war, Congress introduced the limit on aggregate borrowing to streamline the process.
Government spending, and by implication government borrowing, is one of the dividing lines between Democrats and Republicans. From time to time, control of Congress and the White House changes. Each party may decide to use limitations on spending and borrowing as a way of pursuing their political objectives. There have been numerous instances of this over the years.
Failure to raise the debt ceiling would eventually result in a default on US debt. Similar episodes in the past have caused shutdowns of the US government, with federal employees being sent home without pay. Shutdowns are caused by Congress not authorising spending, which is subtly different from not authorising borrowing.
Previous instances of the debt ceiling causing a flirtation with federal default took place in 2011 and 2013. During the first of these, the market did perform poorly. Whilst the US did not default, brinksmanship over the issue highlighted how politics could cause it to in the future. In response, Standard & Poor’s took the extraordinary and controversial step of downgrading the US credit rating. However, probably the greater impact on the market at this time was coincident concerns over the servicing of government debt by some peripheral European countries. In 2013, as is the case so far in 2023, stocks were broadly able to continue rising while the politicians clashed.
The art of the deal
There has always been an assumption that a deal on the debt ceiling will be reached, even with an acknowledgment that the path to a deal was getting narrower. The standoff has been triggered by Republicans taking control of the House of Representatives, but their margin of control is very small. This means passing an increase will require almost all of their number to support it. They passed a bill called the Limit, Save, Grow Act which would reduce spending in 2024 and limit spending increases in the subsequent ten years to 1% per annum. It would also repeal clean energy tax credits and student loan forgiveness, which the previous Democratically controlled Congress had passed. And it would increase the requirements to work for many welfare recipients. President Joe Biden, however, promised to veto that bill should it arrive at his desk. He had consistently demanded a clean debt ceiling increase (meaning one that did not change fiscal policy in other ways).
This past fortnight has seen negotiations taking place on a compromise between the Democratic and Republican positions. It is worth being a little sceptical about the ease of reaching such a deal because the thin majority which the Republicans have in the House means a handful of fiscal hawks could withhold their support and scupper any deal. On that basis, the positive-sounding rhetoric around negotiations is encouraging, but could be misplaced. Ultimately, while both sides may use the threat of default to extract concessions from the other side, neither would want to be responsible for a default. A deal is therefore likely.
Despite the risk of political dysfunction, treasuries are widely considered to be the safest and most liquid assets in the world. This makes it difficult to identify safe havens in the event of a default on treasuries. Paradoxically, the bonds themselves would likely be relative outperformers if the unthinkable did happen. However, one of relatively few alternatives which would likely benefit is gold. After a strong run during 2023, as markets saw default risk increasing, this week the yellow metal has lost some of its lustre.
Gold has also been a beneficiary of efforts by many countries to diversify their foreign exchange reserves, which seems likely to continue. For some countries, this reflects a shifting emphasis away from the US and towards China, with the latter offering investment but requiring less in return in the form of aligning values or participating in collaborative foreign policy (like sanctions).
China’s monthly economic data release underwhelmed earlier this week. Retail sales rose by more than 18% year-on-year, but this number is flattered by an easy comparison with 2022’s depressed level of activity.
Industrial production and fixed-asset investment were disappointing too. The People’s Bank of China (PBoC) expanded its medium-term lending facility to provide additional liquidity to the economy but left the interest rate unchanged. The Morning Consult index of consumer sentiment, which had been rising since China dropped Covid-zero restrictions, has begun to flatten out. The momentum that the Chinese economy had achieved seems to be faltering and, for now at least, policymakers are not coming to the rescue. One reason for their caution could be the falling Chinese yuan, which prompted a PBoC statement this morning calling for action against what it called “one-way market behaviours”. This is assumed to mean currency speculators. The yuan fell to its lowest against the dollar in six months.
Back to the US, and the outlook for growth remains positive, even if economic momentum is slowly ebbing. The Atlanta Fed GDPNow model suggests that gross domestic product (GDP) in the second quarter is running at 2.9%. That estimate will be volatile, but this week’s retail sales data – which will feed into the personal consumption expenditure component of GDP – reinforces the general mood of a gradual slowdown in economic activity. One notable change to the estimate is the implicit bottoming of residential investment, which GDPNow estimates will no longer be a drag on growth this quarter. This critical sector of the economy has been depressed by high mortgage rates, although these have not changed materially this year, despite the increases in short-term interest rates. New prospective buyers are beginning to emerge, but transactions remain depressed by borrowing costs and lack of available housing stock.
The week has ended up being a reassuring one for regional banks, which recovered a little of their lost ground, although deposit outflows from the US banking system overall continued.
The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.
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