The Debt Ceiling and Fears of Recession
The Debt Ceiling and Fears of Recession
“Blessed are the young for they shall inherit the national debt.” – Herbert Hoover
When 2023 kicked off, there were two storylines every economist, analyst, and financial advisor were keeping an eye on. Two potential crises that could upend the markets. I’m referring, of course, to the debt ceiling and the possibility of a recession. Recently, congress was able to get together and resolve the debt ceiling. After weeks of negotiations, President Biden and House Speaker Kevin McCarthy struck a deal to suspend the debt ceiling until January 1, 2025. That removes the possibility of the U.S. defaulting on its debt obligations, which would certainly have triggered a massive recession. As you know, the debt ceiling is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations.”iWhat are these obligations? Think Social Security and Medicare benefits, Military salaries, Tax refunds, and interest payments on Treasury bonds. Here’s a brief look at what’s in the deal. First, and most importantly, is the aforementioned suspension of the debt ceiling. Rather than raising the ceiling to a new number, Washington has negated the idea of a debt limit altogether for the next eighteen months. This means the government can borrow above the current limit in order to meet its existing obligations. In return, both sides of the political aisle have agreed to cap future domestic spending to 1% through the 2025 fiscal year.ii Given that this number is lower than inflation, this effectively amounts to a spending cut. The deal also ends the White House’s pause on student loan payments, while adding new work requirements for Americans who qualify for food stamps and other government assistance. For the economy, however, the deal is less important for what it does than for what it prevents. If the U.S. had breached the ceiling and defaulted on its debt payments, the impact would have been severe for many people. Seniors would have stopped receiving Social Security payments, or at least experienced delays. Child Tax Credit payments, paychecks for federal employees, veterans’ benefits, Medicare benefits…all would have been either curtailed or delayed. Less gut-wrenching on a human level, but equally impactful financially, is what a default would have meant for the bond market. In a default, bondholders would no longer have been paid. The value of their bonds would have plummeted. This would have led to dramatically higher interest rates on any new debt issued in the future, which in turn would mean higher rates for everyone. Given that rates are already higher than they’ve been in years, this would have likely plunged the economy into a deep recession. And since Treasury bonds are historically the most stable investment in the world, it would probably have disrupted international bond markets, too. The result? A global recession. Thankfully, the debt ceiling deal prevented this crisis from unfolding. And while politicians on both sides of the aisle are reportedly unhappy with some aspects of the bill, the risk of default was simply too great. It should be noted that the problems creating the large national debt were not solved with this deal. The can was again kicked down the road, but with every debt ceiling showdown the can gets kicked less far and less far, and we are soon reaching a point where major changes will need to be made before the debt truly gets out control.
Federal Reserve Policy
For the past 18 months, the Federal Reserve has been steadily raising interest rates to bring down inflation. At the start of the year, many economists predicted these rate hikes would lead to mass layoffs and lower consumer spending. The two main causes, in other words, of most recessions. Thus far, however, neither of those things has come to pass. Consumer spending actually rose by 0.8% in April, up from lower increases in February and March.iii The labor market, meanwhile, has proven incredibly resilient. The most recent report indicated the economy added 339,000 new jobs in May.iv That’s far more than experts predicted. The report revised the numbers for March and April, too, with both months bringing more job growth than initially thought. The upshot of all this is that the economy is doing far better than forecasters expected. Does it mean a recession is off the table? No. But it does mean a recession isn’t a certainty this year, either. In Jerome Powell’s latest testimony to congress, he reiterated that despite inflation cooling, bringing inflation down is the number 1 priority of the Federal Reserve. The Federal Funds rate is now above 5% into what many economists refer to as “neutral.” Meaning the Fed is no longer constraining or promoting economy growth. They also continue to tighten the balance sheet, meaning they are not injecting money into the economy via “quantitative easing.”
Higher Interest Rates and the Debt
The fight against inflation has been done primarily through higher interest rates. By making money more expensive to borrow, people with cut back on spending and reduce demand for goods and services allowing prices to naturally come down. The American consumer is feeling it and now too, the American Government is feeling it. Below is a chart of interest payments on the national debt now growing to $928 billion and closing in on $1 Trillion. Bear in mind that this is only just the interest on the debt. This interest payment is now greater than the military budget or what we pay in Medicare or Medicaid.
On a going forward basis, the Fed will need more help from Congress in reducing spending in order to maintain low inflation. I also foresee greater tension between Congress and the Federal Reserve as the National Debt continues to grow. The United States is now over $32 Trillion in Debt and that number is projected to continue to rise rapidly.
With a lot uncertainty in the markets, we have increased our holdings in precious metals this year. Gold and silver are historically uncorrelated to the overall market and can be a great place to “hideout” during weak markets. Precious metals currently have the strongest relative strength in the commodities space as indicated below. This chart is provided by Dorsey Wright & Associates and helps us when allocating client money.
From a financial planner and asset managers point of view, the first have of 2023 has been frustrating due to the lack of market breadth. In 2023, 4 companies have led the S&P 500 higher; Amazon, Microsoft, Apple, and Nvidia. These 4 stocks are the biggest tech giants, by market cap, in the S&P 500 and that means they have the greatest weight. Therefore, their returns have a huge sway on what the index as a whole does. The S&P 500 has 500 stocks that equal approximately $37 Trillion in total value. If the index were equally weighted, each stock would be 0.2% of the index. However, the top stocks of the index keep getting bigger while the bottom ones have remained relatively unchanged. The top 10 stocks in the S&P 500 now make up a shocking 32% of the index, or 16 times what an equal weighting would suggest! This means that the remaining 490 stocks have done very little with most stocks either flat or negative on the year. Artificial Intelligence or AI has been the buzz that has pushed so much money into these names.
Pulling It All Together
I remain mostly optimistic about the market. Inflation is slowing and the economy remains relatively strong. The dominating names in the technology sector are due to take a breather. Some fund managers and investors will no doubt chase these names here but what has worked for the last 6 months will most likely not work for the rest of the year. We need to be forward looking when looking for opportunities today. Here at Carlson Asset Management, we will continue to keep our focus on great businesses, and not the latest hype. I think the AI buzz will be short lived even if the technological breakthroughs are life changing. Over a long period of time, keeping an equal weight and level approach to the market is what wins. I think with how top heavy the market is right towards a select number of stocks, it would only be natural to see them pullback and allow the rest of the market to participate. Maintaining conviction and patience are some of the harder things to do in investing but that’s what great investors do, and in the end patience is rewarded.
Bruce Carlson, CFP®
President Carlson Asset Management
“Debt Limit,” U.S. Department of the Treasury, https://home.treasury.gov/policy-issues/financial-marketsfinancial-institutions-and-fiscal-service/debt-limit
ii What is in the Debt Ceiling deal agreed by Biden and McCarthy?,” Reuters, June 1, 2023. t What is in the US debt ceiling deal agreed by Biden and McCarthy? | Reuters
iii “U.S. Consumer Spending Jumped in April,” The Wall Street Journal, May 26, 2023. https://www.wsj.com/articles/consumer-spending-personal-income-april-2023-b1b57c31
iv “The US economy added 339,000 jobs last month,” USA Today, June 2, 2023. Jobs report for May 2023: 339,000 jobs added despite high inflation (usatoday.com)
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The article and any opinions expressed therein are those of Carlson Asset Management and do not necessarily represent the opinions or strategies of Dorsey, Wright & Associates, LLC