by Krystal Daibes Higgins, CFA
Vice President, Equity Research
Many people believe the world’s largest and most important economy is on the brink of default. Indeed, politicians generally do a disservice by pushing their agenda until the last minute and then lose the trust of their constituents and investors. However, negotiations on the debt ceiling have improved over the last few days and the risk of default has decreased.
While negotiations started off slowly, our optimism improved throughout the week for several reasons. First, it’s interesting to note that the House of Representatives already voted to raise the debt ceiling in April. Their vote included conditions known to be unacceptable for Democrats, but it was a start. Remarkably, members who vowed to never vote (or have never voted) for the debt ceiling helped to push the narrow lead. The debt drama we are seeing today is a matter of how to raise the debt ceiling. Several of the critical pieces of negotiations include rescinding unapproved COVID-related spending, a debt ceiling timeline that extends beyond 2024 elections, work requirements for government aid, spending caps and energy permitting. As the week progressed, politicians moved closer to an agreement, and, as of this morning, it appears that negotiations may have concluded. We now expect to be entering the “procedural” stage to get the debt ceiling lifted.
To be clear, we are not disregarding the risk of a default. In fact, Fitch already placed the United States AAA rating on “rating watch negative” on Wednesday. As we learned in 2011, even if the government avoids a technical default, rating agencies can still issue a downgrade that could set off a cascade of shocks to markets around world. However, should our government reach a technical default, we learned from a 2013 Federal Reserve and Treasury conference call that interest on debt would be prioritized. In addition, there is a mechanism in place for the Treasury to continue paying interest even during a government shutdown. Many investors remain worried and are asking what the actual worst-case scenario would look like. We believe that in the unlikely event of an default, we would see more than a trillion dollars of spending shut off that would result in a contraction in GDP if sustained, accompanied by elevated market stress and volatility. We believe this disruption would be short-lived, however, and that the U.S. economy would continue to lead over the long term.
Amid the debt drama, the S&P 500 continues to grind higher as the largest U.S. companies pull margin levers and report better-than-feared profit declines this past earnings season. A very small number of large companies are driving returns higher, masking some of the pain felt by smaller companies in the S&P 500. Companies with exposure to artificial intelligence (AI) innovation have been the biggest beneficiaries so far this year. This week, NVIDIA, a leader in enabling AI, had a tremendous quarter and revised revenue guidance significantly higher thanks to demand for its semiconductor chips. Within an hour after the company reported, its market value increased by $175 billion—the same size as Nike.
Finally, inflation figures came out this morning modestly higher than expected. The April personal consumption expenditure (PCE) was up 0.4% over the previous month, indicating that above-target inflation remains persistent. This reading means that the Fed is likely to keep interest rates at current levels for longer and it increases the low probability of another hike later this year. However, with businesses under pressure and some early signs of cracks in the economy, we believe the Fed should continue its “pause” in rate hikes in the event we see further U.S. economic growth deterioration.
Takeaways for the Week:
The debt ceiling debacle will likely get resolved, but it’s come with some pain for investors as uncertainty remains high
Large-cap companies continue to drive the market, particularly those businesses driven by AI technology
Inflation remains sticky, which will likely keep interest rates higher for longer