Stocks Eye Debt-Limit Talks
What happened last week?
- The S&P 500 gained 1.65%
- The Dow Jones added 0.38%
- The Nasdaq composite rose by 3.04%
3 Things to Know
If a debt ceiling compromise is reached
Once the 2023 debt ceiling “crisis” passes, US markets will face “late cycle” conditions, as tight monetary policy from the Fed seeks to weaken labor markets.
The debt ceiling negotiation is likely to result in further fiscal tightening and may help the Fed achieve its aims, but it comes at the cost of reversing policies that boosted personal and corporate income over the past few years.
As expected, disagreement and further negotiations between the two parties will continue into the coming week. Given that any compromise is likely to reduce or delay government spending, it’s likely to be a net negative for corporate profits and consumer spending.
That said, the most important determinant of share prices over the next two months is likely to be corporate profitability and the degree to which unemployment rises. We suspect the most recent equity gains may reverse in the months following the resolution of the debt ceiling crisis of 2023.
Citi Global Wealth Investment’s latest economic forecast
The US Fed’s excessive actions provided broad and sustained stimulus during the post-Covid recovery, exacerbating supply/demand mismatches.
Subsequently, the Fed has chosen to tighten monetary policy more rapidly than ever before.
What does this mean for investors?
In our view, the full economic effects of this tightening cycle haven’t been fully realized. The Fed raised policy rates to 5.125% this month and continued Quantitative Tightening. These actions were taken even as the US Index of Leading Economic Indicators was trending down 8% over the past year. While the “strong” economy and Fed policy appear to be on a collision course, pent-up demand and positive inertia from the post-Covid rebound reflect a stronger US economy than we anticipated through early 2023.
Mega-caps drag market higher, smaller stocks look more appealing
On the surface, the year-to-date equity rally looks healthy at +7%, on pace with a typical year’s annual return. But under the hood, the rise has been far from broad-based.
Of the $5.5 trillion in global market cap created this year, 52% can be attributed to just 10 companies (there are 2,880 companies in the MSCI AC World Index).
Year-to-date winners include US mega-cap technology names, European luxury giants that benefit from China’s reopening, and the world’s largest oil company. While the cap-weighted S&P 500 is up 7%, the average return across S&P 500 constituents is -0.8%.
Aggressive monetary and fiscal stimulus lifted all shares in 2020 and 2021, to the outsized benefit of smaller, more beaten-down firms.
In the 12 months following the market lows in March 2020, the Russell 2000 index returned 138% vs 80% for the S&P 500. But the ensuing environment of surging inflation and sharply rising borrowing costs turned out to be much more amenable to large firms with scale, balance sheet strength and pricing power.
Meanwhile, smaller firms have struggled. Indeed, US small caps have completely given up their outperformance versus large caps in the post-Covid era.
As a result of their tepid performance, valuations have improved, with profitable small and midcap names now trading at 14x trailing 12-month earnings, a 26% discount to their larger brethren.
See our weekly CIO Strategy Bulletin for more details