Negotiators Furiously Walk Out of Congressional Debt Ceiling Meeting: May. 19, 2023

Markets quickly sank this morning after Republican lawmakers stepped away from the negotiation table, with GOP Representative Garret Graves claiming the White House team was being unreasonable. During the past few days, perceived progress on negotiations over the thorny debt ceiling issue caused markets to rally despite considerable uncertainty about the passage of a bill that will pass both chambers of Congress if brought to a vote next week. Some House republicans led by the Freedom Caucus are reluctant to accept a deal that doesn’t curb spending to their standards while some House democrats are opposed to shrinking funding for social services. Graves’ comments this morning highlight the highly uncertain nature of negotiators reaching a deal. Meanwhile, the discrepancy between market participants and the Federal Reserve’s monetary policy expectations are shrinking as the higher-for-longer interest rate mantra sinks in. 

Debt Ceiling Pessimism Grows

Investors are reassessing the outlook for a resolution to the debt ceiling crisis following the comments from Graves this morning. While political parties in the past few days have expressed optimism about the government avoiding a default on debt, negotiators have little wiggle room as a failure by Congress to pass a debt agreement next week would make it unlikely that a deal could be reached prior to the estimated June 1 date at which the government will be unable to make debt payments. Despite optimistic comments, negotiators appear far apart in reaching a compromise. The conservative Republican Freedom Caucus urged House of Representatives Speaker Kevin McCarthy to break off negotiations if President Biden doesn’t embrace significant cuts while various progressive Democratic leaders have spoken out against reforming social programs. Progressive Caucus Chair Pramila Jayapal of Washington has said many members of the group were alarmed when Biden suggested he might accept increasing the requirements for individuals to qualify for social services, such as food stamps and Medicaid.

Fed Remains Disciplined

Recent Fed speakers have shifted the markets’ thinking on the rate hike path. While the likelihood of a 25-basis point (bp) hike at next month’s meeting dropped after Fed Chairman Powell mentioned that tighter bank lending may help the Fed in its inflation battle, expectations of rate cuts have been pushed back from September to November. Expectations of persistent inflation and a tighter Fed have propped up the 2-year and 10-year Treasury yields to their highest levels since March, pressures that drove the regional banking sector into severe strain amidst three bank failures. As Chairman Powell recalled the hardships of inflation during the 1970s, he reaffirmed that the committee remains steadfast in achieving their two percent inflation goal.

Markets Reverse on Debt Ceiling Pessimism

Equities were rallying and reached fresh year-to-date highs until news of stalled talks on Capitol Hill encouraged selling. The S&P 500 Index reached 4212.91, its highest level all year until selling pressure emerged, it’s now down 0.3%. Bond yields of one-year duration and longer were higher in the morning but pulled lower after Powell implied that tighter credit standards are going to constrain economic activity enough and do some of its work for the central bank. The 2-year Treasury yield and 10-year are roughly unchanged at 4.25% and 3.65%, after falling from their highest levels since March of 4.35% and 3.72% respectively. The 1-month Treasury yield ,meanwhile, is up 15 bps on higher risks of a U.S. default. The Dollar Index is taking a break from its recent rally as Powell’s comments dropped odds for another 25-bp hike, its down 48 bps to 103.09. WTI crude oil was higher on debt ceiling optimism but receded following objections in Washington, its down 0.3% to $71.72 on the threat of recession resulting from continued disagreement.

Consumers Weaken but Some Industries Hold Up

Inflation is causing shoppers to be more budget conscious, but certain non-retail industries are experiencing growing demand, at least in certain sectors. These themes are illustrated by the following earnings reports:

• Ross Stores, an operator of off-price department stores called Ross Dress for Less stores and dd’s Discounts, posted earnings per share (EPS) of $1.09 for the first quarter compared to $0.97 in the year ago quarter and above the consensus expectation of $1.06. Its $4.5 billion in sales climbed from $4.3 billion year-over-year (y/y), a 3.7% increase, and matched the consensus expectation. The company’s same store sales, however, increased only 1% y/y. Ross Chief Executive Officer Barbara Rentler noted that continued inflationary pressures were impacting spending by the company’s low-to-moderate income customers and same-store sales during the current quarter are expected to be relatively flat y/y. The company is forecasting an EPS of $1.07 for the current quarter, which would be a decline from $1.11 for the same quarter in 2022.
• Deere & Co., which manufactures and distributes agricultural equipment, homeowner yard tools and heavy machinery under the John Deere brand, posted $9.65 EPS compared to the consensus expectation of $8.57. Its net income of $2.8 billion climbed up y/y from $2.1 billion while its adjusted revenue of $16.08 billion beat the consensus expectation of $14.8 billion. Deere Chairman and Chief Executive Officer John C. May said supply chain issues continue but are improving. At the same time, the company is benefiting from strong demand among farmers who need to replace aging equipment. Deere expects 2023 net income in the range of $9.25 billion to $9.50 billion, higher than the $8.75 billion to $9.25 billion forecasted earlier.
• Applied Materials, which provides equipment for manufacturing semiconductors, posted profit of $2 a share excluding certain items for its fiscal second quarter ended April 30. Its profits climbed 8% y/y from $1.85 a share and exceeded the analyst expectation of $1.83 per share. Applied Materials’ sales for the quarter of $6.63 billion climbed from $6.24 billion for the year-ago quarter, a 6% increase and exceeded the analyst consensus expectation of $6.37 billion. Sales of equipment for computer memory manufacturing have weakened due to sluggish end market demand for smartphones and personal consumer. The impact on total sales from weakness for those types of products was offset by strong demand for equipment used for manufacturing silicon chips for automobiles and industrial applications. Chief Executive Officer Gary Dickerson said recently that the company is facing challenging economic conditions in addition to a glut of computer member chips.

Economic and Capital Market Headwinds Persist

Going forward, the following headwinds are likely to continuing challenging risk assets:

• Yields have reached the same levels as early March when regional banks were forced to sell held-to-maturity bonds at steep discounts to meet redemptions.
• The Fed is reducing its balance sheet at a rate that puts it four weeks away from reaching the level it was at prior to the regional bank failures.
• The economy is slowing and inflation remains sticky

Clearly, significant challenges exist for risk assets and investors with an overly optimistic outlook may be walking on an unrealistic dream. Debt ceiling negotiations are a lose-lose for equity investors at this juncture, as a failure to strike a deal will lead to an immediate recession while a deal will strain liquidity from markets as the U.S. Treasury issues trillions in new bonds, which are newly born and will serve as additional competition to other assets like stocks, corporate bonds, mortgages, bank loans, etc. With strong investor optimism occurring alongside growing risks in capital markets, content from artificial intelligence (AI) goggles may offer a dose of reality, or the right prescription, for investors that are unphased by significant downside risks as they experience AI induced delusions.

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