This week in the podcast, we’re focusing on the debt ceiling. Two big things you need to know: First, we see debt ceiling drama as a contributor to choppiness in US equity markets later this year, though we ultimately expect a deal. This was a hot topic in our meetings with UK investors last week. Second, we see Health Care as one of the most vulnerable sectors in the short term but would be buyers on weakness.
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Now, let’s jump into the details.
Let’s start with takeaway #1: we see debt ceiling drama as a contributor to choppiness in US equity markets later this year, though we ultimately expect a deal.
We spent last week in the UK speaking with equity and derivatives investors about our views on US equity markets. Surprisingly, the hot topic that most wanted to discuss was the US debt ceiling. This was true even before McCarthy’s bill passed the House on Wednesday.
Most of the investors we spoke with had a negative view on US equities and saw the debt ceiling as something that stood a reasonable chance of sparking a pullback in US equities in the coming months.
We don’t agree with our UK-based clients on their negative view of the US. Overall, we continue to feel neutral.
But the debt ceiling is one issue where we do find some common ground. In our discussions last week, we revisited the work we published back in late February (when we found it was difficult to get our NYC-based hedge fund clients to even pay attention, even though many of the long-only clients were asking about it). Our main conclusion remains that US equities have been highly sensitive to debt ceiling headlines in the past and have a role to play in getting Congress to come to an agreement.
We took a look back at how the S&P 500 traded around the major events associated with the various debt ceiling dramas dating back to 2011 and took away a few key lessons:
First, the worst debt ceiling dramas for stocks occurred when angst was already high in financial markets for other reasons and total declines ranged from 10-19%. 2011’s 19% drop, for instance, occurred when fear regarding the European sovereign debt crisis was also high.
The nearly 12% drop in the late summer of 2015 occurred against the backdrop of rising recession fears.
And the 10% drop in early 2018 occurred alongside the unwind of the low vol trade.
Second, in other periods, when there wasn’t nearly as much drama in financial markets generally, S&P 500 losses around major debt ceiling developments were more modest, in the 2-7% range, with most amounting to 5-7%. We saw this in 2013-2014…
As well as 2019….
And in 2021, when Congress had a difficult time getting to an agreement even though Democrats controlled all three branches of government. It too a 5% hit to markets to convince Congress to act.
Back in February a 5-6% hit was the scenario we thought was most likely in 2023, but the loss of confidence from the recent banking crisis has increased the likelihood of a more significant breakdown of 10% or more. That’s not our base case, but its chances have risen in our minds.
And third, there were several instances in which the stock market didn’t react much to the first round of warnings on the debt ceiling, but sold off around the second wave of warnings. That feels like where we are today. Last week the investors seemed unnerved about the idea that the x date estimate was moving up. Tuesday, Yellen’s letter proved their fears were well founded when she indicated that the x date would be June 1st, even earlier than the July timing the investors we spoke with last week were talking about.
Ultimately, we’d see a debt ceiling-induced pullback as a buying opportunity for stocks. But for now, the issue argues against raising our YE S&P 500 price target of 4100.
Moving on to takeaway number two: we see Health Care as one of the most vulnerable sectors to debt ceiling drama in the short term but would be buyers on weakness.
One question that kept coming up last week was what sectors would be most vulnerable in a debt ceiling-related drawdown. We referenced our February work in which we reviewed debt ceiling commentary in recent company press releases, transcripts, and filings (the footnotes of financial statements were surprisingly useful). That exercise indicated that Health Care was one of the sectors citing the issue as a risk factor most often. This was due to higher exposure to government spending programs, reimbursement concerns, and FDA/clinical trial exposure.
Industrials was another, mostly Aerospace & Defense companies, which exposure to government spending programs also highlighted.
Banks had been highlighting the issue in the context of the matter creating problems for financial markets.
To provide some additional context, we’ve taken a quantitative look at how the level of discussion on the debt ceiling today compares to the past. This work suggests to us that debt ceiling worries have spike for Corporate America.
The level of chatter is closing in on, but hasn’t quite reached, 2011 levels (the worst debt ceiling drama in recent history when the S&P 500 lost 19% peak to trough) and it’s right back at 2013-2014 levels, another big spike in the past.
In terms of sectors/industries, Health Care commentary has moved back to 2011 and 2013-2014 levels.
This was also true for Aerospace & Defense.
By contrast, Banks are talking about the issue much more than they did in 2011 and 2013-2014.
While we haven’t had a strong view on Aerospace & Defense companies and prefer to stay on the sidelines with Banks, the debt ceiling admittedly complicates our constructive view on Health Care. We have been overweight Health Care, and have been pointing out recently that the sector has become the most reasonably valued defensive sector in the S&P 500.
Other things we like about the sector have included constructive views from our analyst teams and the improvement we’ve been seeing in EPS revisions trends for the S&P 500 version of the sector. Given the higher level of risk disclosure, we suspect Health Care would not act defensively in a debt ceiling-driven drawdown. But given our expectation that a deal will eventually be reached and the reasonableness of current valuations for the sector, we’d use any debt ceiling weakness in the sector as a buying opportunity.
Before we wrap up – one last thought.
Another question we got last week was how worried are we that Washington won’t get a debt ceiling done? Ultimately, we do think a deal will get done. Polling data suggests that while American voters don’t like the idea of raising the debt ceiling, they dislike the idea of the US defaulting on its debts even more and don’t appear to have much of an appetite for major cuts to programs like social security, Medicare, and Medicaid or defense spending. Neither Republicans nor Democrats will want to be blamed for failure here heading into an election year. But we also think the potential for major drama is higher this time around given the thin margin in the House, the structural difficulties McCarthy has maintaining his leadership, the fact that both parties believe they have a chance to win control in 2024, and the low chances that Democrats will give in to McCarthy’s demands to cut spending for their biggest legislative wins like the IRA. The path to compromise has been extremely difficult to see, increasing the need for the stock market to throw a temper tantrum to get Congress and the White House to do the right thing. We are excited that the two sides are finally talking, with a bipartisan meeting set for May 9th.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.