US debt ceiling crunch threatens to roil complacent stock market

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., May 22, 2023. REUTERS/Brendan McDermid

Even as stocks continue to climb, strategists at some of Wall Street's largest institutions sound increasingly concerned about potential market fallout from the impasse over raising the U.S. debt ceiling.

The S&P 500 has increased by more than 9 percent this year and is near its greatest level since August 2022. As the deadline to avert the first-ever catastrophic U.S. government default nears, equity investors appear unconcerned, partly because they are confident that legislators will eventually reach an agreement.

With equities trading at historically high valuations and the Federal Reserve's policy rate at a 15-year high, some strategists warn that the stock market could become volatile in the days leading up to June 1, the so-called X-date, which the Treasury Department has identified as the date the government could run out of money to pay its bills.

"The market appears more susceptible to volatility surrounding the debt ceiling heading into this week," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. If a problem arises within the next week, it could be repriced into markets.

President Joe Biden and House Speaker Kevin McCarthy concluded talks late on Monday with no agreement on how to raise the U.S. government's $31.4 trillion debt ceiling; they will continue to negotiate with less than two weeks remaining before a potential default.

Calm For Now

The Cboe Volatility Index, also known as Wall Street's dread gauge, is near its lowest level since late 2021, even though bond markets have been plagued by anxiety.

Even as the deadline approaches, investors believe an agreement is likely for now. Seventy-one percent of global fund managers surveyed by BofA Global Research last week believe an agreement to raise the debt ceiling will be reached before the X-date.

Nevertheless, some are concerned that the current market and economic environment may make stocks more vulnerable than in 2011 when a debt-ceiling-related standoff led to a historic downgrade of the United States' credit rating.

According to JPMorgan's strategists, the current market environment could be worse for risky assets than during the 2011 episode, as greater inflation, higher valuations, and tighter monetary policy could make the current market environment worse for risky assets.

According to Refinitiv Datastream, the S&P 500 is trading at approximately 18.4 times forward earnings estimates, compared to its historical average of 15.6 times. According to JPMorgan, this ratio was just over 12 times in the summer of 2011.

Other benchmarks are also less favorable: The Fed's most aggressive rate-raising cycle in decades has resulted in a range of interest rates between 5% and 5.25 percent, compared to near zero in 2011. Inflation stands at 4.9% annually, compared to 3.6% in 2011, while S&P 500 forward annual earnings are projected to increase by 5.7%, compared to 15.3% in 2011.

As in 2011, the bank's analysts noted that a narrow vote could be enough to roil the markets.

JPMorgan wrote that while they anticipate a resolution in the end, "the journey to that end could... drive significantly higher market volatility than is currently appreciated by the market."

UBS Global Wealth Management, meanwhile, stated in a report published last week that it anticipates a 10% decline in the S&P 500 if legislators fail to reach an agreement by the X-date, although this is not its base case.

"Historically, equity volatility does not show signs of stress until the X-date approaches," the firm stated in a separate note last week. "If the market does not place a high probability on a resolution by the beginning of the following week, we anticipate an increase in equity volatility along with T-Bill yields and credit default swaps."

Henry Schwartz, global head of client engagement, data & access solutions at Cboe Global Markets, stated that despite the relative calm in the VIX, there had been recent large options trades that would pay out if the fear gauge jumped to record highs in the coming months, indicating concerns over a sharp market decline.

Schwartz stated, "It almost suggests a binary outlook: either they settle it (the debt ceiling issue) and the VIX remains at 17, or we default, and the VIX rises to 90."

Publish : 2023-05-23 14:56:00

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