In February, when the Congressional Budget Office projected that the US government would run out of money this summer, Joe Amato, president and chief investment officer of private equites at Neuberger Berman, suggested that investors should consider that to be just as important as they considered the outlook on inflation and rates.
Amato did not think the US would default on its debt, but he warned that the threshold could still be ‘a source of volatility over the next three to six months.’ Over recent weeks, it has become a top concern for investors, although from our perspective it represents merely one among several potential trip hazards.
Despite the increasingly frequent headlines about the risks of hitting the debt ceiling, these concerns do not appear to be making their way into equity markets. Stocks are close to their highs for the year and the Chicago Board Options Exchange volatility index is close to its low.
In our view, every time the risks build up and the markets fail to correct, it reinforces the case for caution on risky assets, particularly while high rates on cash and short-dated fixed income mean investors are being ‘paid to be patient’.
There is growing alarm that the debt ceiling is closing in. Still, the consensus is that Republicans don’t want to be blamed for the chaos of a default (as evidenced by the bill they passed in the House of Representatives in April), Democrats don’t want the issue to be postponed into an election year and therefore a last-minute compromise will be reached. Perhaps a calm market is the appropriate response.
We don’t think so. The US didn’t default in 2011, but it got close enough for the S&P 500 index to lose almost a fifth of its value. If things go to the wire, the government may have to temporarily halt government spending to make interest payments, creating what could be an additional growth shock to an already faltering economy.
Markets aren’t entirely ignoring the risks now. The spread between the yields of one-month and three-month Treasury bills has been exceptionally wide and volatile. Similarly, while the VIX is near its 2023 low, the Merrill Lynch Option Volatility Estimate (the equivalent of the VIX for bonds) has been bouncing around at historically high levels. It may be only a matter of time before that nervousness spills into equities.
Warning against complacency
For more than a month, it seemed that the banking-sector stresses that broke out in March had been contained. The shares of First Republic Bank, perceived to be the most likely next casualty, had stabilised at around $14. But First Republic’s disclosure that first-quarter deposit withdrawals were bigger than analysts had estimated halved its share price again, sending a new shockwave through the wider sector.
That is likely to raise further concern about leverage and financing pressures in certain parts of the US commercial real estate industry, to which the vulnerable regional banking sector has been an outsized lender. This is a segment of the market that we are watching closely.
While there may be no more First Republic-magnitude shocks and large-cap technology appears to be holding up well, we have long anticipated that the earnings picture will deteriorate significantly as we move through the year. Those expectations are getting support from weakening economic data (a US gross domestic product slump in the first quarter), tighter credit conditions and stubbornly persistent inflation and central bank hawkishness, especially in Europe and the UK.
Cautious, liquid and flexible
This is a long list of obstacles waiting to trip up markets during 2023. It is possible that none causes a major incident. But we think it is probable that at least some of them will significantly slow down progress.
We believe investors can benefit from remaining cautious, liquid and flexible over the coming months, ready to take advantage should markets take a fall. High rates at the front end of yield curves mean there is little opportunity cost to doing so, should things turn out better than expected.
Erik Knutzen is Chief Investment Officer, Multi-Asset Class at Neuberger Berman.
This article was originally published by Neuberger Berman.