A remarkable feature of stock markets is their propensity for cognitive dissonance, where deeply held beliefs or behaviours are tested by conflicting new information. As I write this, the US Federal Reserve (Fed) Chair Jay Powell has announced his policy committee’s decision on interest rates, another hike of 0.25%, now having risen more than 20-fold in a year.

Nevertheless, and despite the Fed’s repeated resolve re combating inflation through tightening financial conditions (ie making money more expensive), markets have been betting that this Fed meeting will be the last to raise rates, with some forecasting a rate cut of 1% by July. This would be a boost to asset prices, and so investors are attempting to ‘get in early’, hence the remarkable recovery in developed world equity prices - particularly in the UK and Europe - despite more obvious headwinds.

April’s economic data showed economic activity and company earnings were stronger than expected, and the areas that benefited best were those most affected by the bad news in March; yet another example of ‘reversion to the mean’ where extremes of price movements generally correct back to their long-term average. In the UK, medium-sized companies outperformed large, rising over 2.5% in the month while the technology-biased US Nasdaq index fell by almost 4% in sterling terms.

Unfortunately, the apparent rise in companies’ earnings seems to be rather more about widening profit margins than increased sales and revenue. The average revenue increases declared by recent companies’ results are around 2%, but the average earnings increase has jumped to almost 7%, implying that continuing inflation pressure is more about ‘price-gouging’ than supply shortages, and interest rate rises can do little to stop that in the short-term. It remains to be seen how much pricing power companies can exercise before consumers become more discerning about prices.

Despite these positive stories, and while data and sentiment suggest a recession is less likely in the near term, the stability of US regional banks remains in doubt, with First Republic Bank collapsing as April drew to a close. This wasn’t a shock; the bank offered cheap mortgages to rich clients using deposited money at virtually zero interest. What happened next is now all too familiar a story - its assets (longer-dated bonds) had plummeted in price through 2022, and depositors panicked and withdrew $70bn during the first 3 months of 2023.  An emergency auction of the bank last weekend revealed that deposits held had almost halved during the quarter. Essentially, the ripple effect of a year of rate rises is still not fully evident – as I write US Bank PacWest Bancorp’s share price has halved on news it is seeking rescue - and despite increasingly good news on the company earnings front, and business surveys being more positive, I believe our continued reliance on the widest diversity of investments remains the most prudent strategy.

We are however keeping a close eye on a rather arcane procedure in the US, the raising of the ‘Debt Ceiling’, which may form a key subject for this commentary next month, so allow me to offer a brief ‘explainer’:

The Debt Ceiling – why it does (but shouldn’t) matter

Most countries don’t collect sufficient taxes to pay their nation’s way, so they borrow to fund the (often enormous) shortfall by issuing debt (e.g., Gilts in the UK, Treasuries in the US). The US ‘debt ceiling’ is a cap set by Congress (the Senate and the House of Representatives) on the total amount of money that the United States is authorized to borrow to fund the government, and meet its financial obligations to its people, e.g., paying social security benefits, and its debtors.

Typically, the elected government presents its annual budget to the legislature (Parliament in the UK) which votes and ultimately passes it. Thereafter the government is free to get on with the job of raising money to fund that budget. The US constitution however requires Congress to authorise not only the budget plan but also any borrowing required to fund it.  In theory that meant the US Treasury had to repeatedly go back to Congress to ‘get permission’ to borrow. However, over a century ago it was agreed that as long as Congress agreed a limit to borrowing, the Treasury could get on with the job if it didn’t breach that limit. In 1939 the limit was $45bn. Today it has reached the eye-watering $31.4 trillion; without an agreement to increase it, and despite some creative accounting, the US government is forecast to run out of cash by June 1st 2023.

If the government does run out of money, it would be unable to issue new debt. That means it would not have enough funds to pay its bills, which include payments to existing holders of government debt eg Treasury Bills. That would constitute a default by the world’s strongest economy and currency, a scenario that is potentially a catalyst for a global-scale financial crisis.

So why not just increase it? Because the process has become a game of ‘chicken’ by which politicians can hold one another’s party to ransom to extract policy concessions. The Republican-controlled House passed legislation last month that agreed a debt limit increase in exchange for trillions of dollars in spending cuts intended to unwind President Biden’s legislative achievements. The President and Senate Democrats, who control the upper chamber, refuse to negotiate on debt limit legislation, demanding an increase without preconditions. There are now calls to abandon the limit altogether.

It seems highly likely some solution – bizarrely including the minting of a $1 trillion platinum coin – will be found in the next few weeks, yet however unthinkable a US default may appear, the price of US credit default swaps (insurance against a bond defaulting on its obligations) have rocketed recently. In the meantime, however uncertain conditions might remain, spare a thought for the population of Argentina. Their annual inflation rate has just passed 102%. Let’s be grateful for small mercies.

See you next month.

Graham Bentley,
Chief Investment Officer

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