Debt Ceiling and Default Risk Resolved: Where from Here?

In this article we review:

• The congressional approval of the debt ceiling extension agreement eliminating default risk in the U.S. Treasury market
• The unexpectedly strong May employment report and its underlying components
• Expectations for the upcoming June Federal Reserve meeting
• An assessment of ongoing recession risk in the year ahead
• Current corporate earnings trends and their potential impact on the markets
• Our current year-end targets on the federal funds rate and S&P 500^®

On May 31 and June 1, the U.S. House of Representatives and Senate quickly approved the extension of the U.S. debt ceiling until January 2025, with four days to spare before the government and the markets may have faced default on U.S. Treasury securities for the first time in the nation’s history. Having been signed into law by President Joe Biden, the Fiscal Responsibility Act of 2023 now provides certainty once again in the creditworthiness of the U.S. Treasury bond market as well as removing a major cloud overhanging the markets.   

With this bizarre chapter of political and market history officially concluded, investors now fully turn to a series of other matters. These include:

May employment report exceptionally strong. Immediately following the Senate’s passage of the debt ceiling extension, the Bureau of Labor Statistics reported a much higher than expected nonfarm payroll number for the month of May totaling 339,000 new jobs added to the economy, well above consensus expectations of approximately 190,000. Markets reacted favorably upon this news as the report was viewed by many to have a “Goldilocks” profile to it in that, despite the strong headline result, underlying components were less economically bullish. This included a jump in unemployment to 3.7% (from 3.4% in April) as a larger portion of self-employed and part-time workers now appear to be seeking full-time work. Average hourly earnings continued to display a downward trajectory at 4.3% year-over-year growth, declining from a peak of 5.9% last March and its lowest rate since July 2021.

Upcoming Fed Meeting. With debt ceiling risk now faded into the background, market focus turns to the upcoming Federal Reserve meeting concluding on June 14. At the current time, we expect the Fed to pass on raising the target range on the federal funds rate, though this is currently a close call, in our view, and could change based on economic data between now and the meeting that will include the June 13 consumer price index inflation report. In addition to the Fed’s decision at this meeting as to whether to take a pause or “skip” on raising rates, the language of the written statement and post-meeting commentary by Chair Jay Powell will also be critical. At the current time, we continue to believe the Fed will conclude the year with a lower bound on the fed funds rate at its current level of 5.0%.

Recession risk in flux. Our base case continues to believe a moderate recession is likely to begin by year-end, although given the expected nature of its arrival and the downward market activity since the beginning of last year, there is good probability markets could quickly look past it. That said, probably our biggest perspective change since the year began has been a shift in expected probabilities from whether the economy in the year ahead will begin a moderate or severe recession to one of whether it will experience a moderate recession or soft landing (no recession). We see the probability of a soft landing as increasing but still in the statistical minority at about 40%.    

The battle of leading versus current economic indicators continues. While coincident indicators such as corporate earnings, unemployment rate, gross domestic product, and jobs growth are yet to appear recessionary in nature, leading economic indicators are telling a more ominous story. This can be seen in the Conference Board’s Leading Economic Indicators Index of 10 economic, consumer, and market metrics, all with an established history of turning negative prior to recessions and that, in aggregate through April, have experienced worse than -8% decline over the previous 12 months. Another signal would be the 3-month–10-year Treasury bond yield curve, which has been inverted since last October (short-term rates higher than long-term rates), a condition that has proven accurate in forecasting all eight U.S. recessions since 1969. 

Earnings season rolls on better than expected. While far from stellar, first quarter corporate earnings have continued to show stronger resilience than most had feared at this point last year. It is important to keep in mind that much of the CY 2022 sell-off in stocks and widening of credit spreads was predicated on a major decline in CY 2023 profits, which is yet to be the case. With official CY 2023 earnings estimates (FactSet Earnings Insights S&P 500 net operating income) now looking basically flat versus last year, we could soon be looking at a scenario of a declining profits year not being as week as expected, and thereby providing upside for stocks as the market turns its attention toward CY 2024 earnings in the months ahead. At this point, we are maintaining our year-end price target on the S&P 500 of 4,400. 

In summary, we are relieved and encouraged by the ability of both chambers of Congress to approve the bipartisan debt ceiling extension agreement in a matter of days, thereby resolving a major risk to the markets. The prospect of a U.S. default on its debt has never previously been something markets have had to seriously consider, yet this time around the negotiating parties involved took matters closer to the edge than ever before. That risk is gone now, allowing markets to once again focus on the more widely recognized wall of worry it continually looks to climb.                      

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