Running On Empty – Why a debt deal could be bad news for stocks

Posted by David Nelson, CFA on May 23, 2023 in Investment Management | Leave a comment

By David Nelson, CFA
 
You’ve probably had this conversation with friends and family. It goes something like this. What happens to my 401k and other investments if Democrats and Republicans can’t come to a compromise over the debt ceiling? U.S. debt is a staggering 31.4 trillion and debt to GDP is at the highest levels since World War II. Unfortunately, rhetoric from both sides of the aisle has shown no sign of letting up.

Bloomberg Data

The iceberg is dead ahead and if the two sides can’t come to terms, the U.S. is looking at another debt downgrade or something worse. It took close to 100 days to get both sides to come to the table but the passage of the House bill raising the debt ceiling with conditions forced the President’s hand, who has now abandoned his refusal to negotiate.

He doesn’t like calling it a negotiation, but when two sides sit in a room and haggle over their positions, guess what? It’s a negotiation.

The first rule in a successful negotiation is to keep the principals in the room. With the President off in Japan at the G7 meeting. It remains to be seen if staffers can get this job done.

As of Friday evening, both sides were pointing fingers, saying the other side was holding firm on extreme views. Talks flipped from on to off to back on again like a light switch. It was unclear as of the weekend exactly when both sides would get back together. The good news, is that the President cut his trip short and both sides have expressed optimism that a deal could be had as early as next week.

Secretary of Treasury Janet Yellen has said, government could run out of funds as early as June 1. Most of the projections for what would happen in the event of a default have been pretty frightening. Moody’s puts the hit to GDP at around 4%, with 7 million jobs lost. Want a black swan event that could trigger a recession? That’s it.

Bloomberg Data

Most traders remember the 18% hit to markets as we approached the debt ceiling in 2011. There isn’t much consensus on what would happen this time, but the range is somewhere between double digit declines in stocks to life would end as we know it. The truth rarely lives on the extremes. So even if we meet in the middle, it’s an outcome most investors would like to avoid.

What happens if we get a deal?

But what happens if talks go well, and Speaker McCarthy and the President cut a deal? Is the coast clear? Are stocks off to the races? Or is the glass still half empty?

It’s counterintuitive, I know, but a deal even before the deadline could actually trigger a selloff in stocks. I know it sounds Looney Tunes. I’m telling you; good news is bad and bad is good.

World War I was the start

Let’s go back to the start. How did we even end up with the debt limit? The Democratic case is the following. Congress passed legislation to spend the money. Why should we have to raise the limit on the credit card every time we bump up against the ceiling? They claim it should be automatic.

History gives us some answers. Its origins go all the way back to World War I. Costs for the war were starting to balloon. We all knew we were going to have to come up with the money for the war, but Congress wanted a say in the process.

It was really meant to be a speedbump, Force the vehicle to slow down. Look at the landscape before you up the limit. It’s been that way ever since. Congress has raised the debt limit 90 times, 78x just since 1960. Oh, by the way, it’s never been lowered.

Bloomberg Data

I think most traders understand there’s going to be a deal, but no one really likes to know how the sausage is made. Treasury has what is known as the general account. It’s kind of like your checking account. You use it to pay bills and so do they. It’s been running down all year. The account gets a bump when tax receipts come in but is now running out of money fast.

Who gets paid first?

Yellen is going to have to make some hard choices. Who gets paid first? Debt holders? If those interest payments aren’t made a default is triggered.

What about Social Security benefits? The Wall Street Journal reports that it is possible there could be reduced benefits or delays in sending out checks. The last thing Washington needs is retirees marching towards the Capitol in wheelchairs or pushing walkers. Trust me, it’s not going to play well on the 6 PM news.

The typical balance of the general account is usually somewhere around $1,000,000,000,000 and of course goes up and down as funds come in and out. Tax receipts, proceeds from the issuance of debt and other revenue all go into the account to keep Secretary of Treasury Yellen from writing bad checks. Given the U.S. runs a large deficit, Treasury is running out of funds fast. Tax receipts and other revenue are still trickling in, so the June 1st drop dead date, also known as the x-date could get a reprieve.

Either way, we’re going to hit the wall and hit it soon. If a natural disaster or some other event hit near that time, the outcome could be catastrophic.
 
So how could a deal still hurt stocks?
 
When your car runs low on gas, what do you do? You pull into the nearest gas station and fill the tank. That’s exactly what Treasury will do.
 
Krishna Kumar CEO of Goose Hollow Capital and manager of the Goose Hollow Tactical Allocation Fund (GHTA) joined our weekly Belpointe Market Lab show on Thursday. He pointed out that when Treasury starts replenishing funds back into the general account stocks could suffer as there is less liquidity in the system.

Bloomberg Data

As soon as a deal is signed, Treasury is going to want to fill up their account so they can start paying bills. The quickest way to do that is to issue debt. That, in turn, will pull funds from the system into T-bills and other debt instruments, some of which might have found its way into the stock market.

In a recent research note, JPMorgan expects Treasury to issue enough debt to get the U.S. Treasury account or TGA back up to $700 Billion. It will take time but eventually markets will come back into balance.

Austerity

We also have to recognize the fact that, like it or not, austerity means reduced spending and that in itself will weigh on economic activity.

The Republican starting point is laid out in the House Bill that passed by the slimmest of margins 217 to 215. Some of the key sections in the bill are the following:

In exchange for a $1.5 trillion hike in the limit, spending levels will be rolled back and some of the President’s signature programs like student loan debt relief and an additional $71 billion to the IRS would be rescinded. Work requirements for able bodied adults under 50 to continue receiving food stamps and other assistance was another key point in the bill.
 
I fully support some of these rollbacks. Student loan debt relief was an insult to the millions of students and their parents who paid off their loans. What did they get? What about the millions who chose to go into the workforce and didn’t get to go to college?

Having said that, I’m also a realist. I understand that in negotiations, neither side gets everything they want and that some of these rollbacks, while in the long run are good for the nation, could cause some short-term pain for stocks as less money is sloshing around the system.
 
Wild Cards

The wild card is Donald Trump. Like it or not, the former President is leading in the polls and therefore the de facto leader of the Republican Party.

He’s already said let the US default. It’s hard to know when Trump is for real and stating preferred policy or just shaking up the opposition. He gave that away in his book, The Art of the Deal. Go for a big ask. It will give you more room to negotiate and ultimately end up with a better deal.
 
Democrats have got their wild card, too. Biden could invoke the 14th Amendment. He would likely point to Section IV and the language that speaks to the validity of the debt. In other words, just ignore the debt limit, keep writing checks and go on with business as usual.

It would, of course, go all the way to the Supreme Court. I’m not a constitutional scholar, but I suspect we’d be right back where we are now.

In late breaking news over the weekend, Speaker McCarthy put out a statement that he doesn’t see any progress being made until the President returns home. That’s code for talks aren’t going well.

Spin Zone

The coming week is going to be all about the spin. You can bet both sides will be shaping the story to play to their base. The mainstream media, like always, will pump up the volume, adding to the chaos.
Buckle up, kids. Coney Island has nothing on this roller coaster.