Forget about the debt ceiling
With the US government forecast to hit the debt ceiling on Monday the 5th of June market anxiety has been on the rise. US Indices rise on as much of an utterance of deal resolution and fall in panic on the hint of no deal. Despite the market volatility we have been reticent in addressing the topic because in short, the debt ceiling is a nonevent. We simply do not believe there will be a US debt default.
US politicians created this drama to give themselves yet another opportunity to appear in front of the cameras. Sure, the excuse for the heated debate is that Republicans are demanding deep spending cuts. However, history proves that they were very likely to cave on these demands. Which is exactly what happened just yesterday when the bill easily passed the Congress by a vote of 314-117. Now that the Senate has also voted to pass the bill all that needs to happen is for President Joe Biden to sign it into law later this week.
We felt confident that Republicans would cave on their demands because we do not believe that they were truly concerned about reducing government spending. During the three years of Trump Administration overall spending rose 13% in real terms and then rocketed higher during the pandemic. Figure 1 below serves as further evidence that during multiple periods of Republicans in office the debt ceiling has risen. In our view, investors should ignore the debt ceiling drama and rather focus on the forces that will have real impacts on financial markets.
Figure 1 – US debt rises irrespective of who is in the White House
The impact of Banks stresses appears contained
In March, several banks imploded as rapidly rising interest rates inevitably caused something to break. That something was banks with poorly diversified loan books and balance sheet maturity mismatches, the poster child being Silicon Valley Bank (“SVB”).
In the weeks following, the question on many investors’ minds was what knock-on effect this would have on the global economy. Fortunately, central banks around the world stepped in by protecting depositor savings and brokering bank mergers in a coordinated effort that appears to have stemmed further contagion. Importantly, these measures steered the financial system clear of a 2008 style crisis and instead will likely impose a slow drag on economic growth. A far more palatable outcome.
The slow economic drag is a result of banks responding to the heightened risk in the financial system by reducing their risk appetite. Banks reduce their risk appetite by raising their lending standards, to avoid lending to borrowers who pose a greater risk of default. The impact of this is fewer businesses and consumers can access credit, inhibiting their ability to spend and thus slowing economic growth.
As we mentioned in the March Market Synopsis, somewhat counterintuitively, we believe tighter lending standards are in fact good for equity markets as slower economic growth helps combat inflation. If inflation slows, the US Federal Reserve (“Fed”) does not have to raise rates as harshly. Lower rates, means that the discount rate used by investors to value equities is lower, and in turn equity valuations should rise.
The US housing market is stabilizing
Housing is the most interest rate-sensitive sector of the economy. Higher interest rates lead to more expensive mortgages, limiting the buying power of prospective homeowners and in turn placing downwards pressure on home prices. These dynamics mean that the housing market is a good gauge of how tight underlying monetary policy is.
The latest data hints that US housing prices are stabilizing, if not outright improving. Since the start of the year singlefamily building permits and housing starts have started climbing again. In addition, new home sales are rising as evidenced in Figure 2. With the cooling of many once overvalued housing markets beginning to slow it appears that housing may avoid a recession-inducing downturn.
Figure 2 – Green shoots in the US housing market
Global manufacturing may be bottoming
The US ISM Manufacturing index indicates that the current manufacturing downturn began around June 2021, 19 months ago. Typically, a full US manufacturing cycle lasts 36 months, with the down-leg lasting roughly 18 months. In other words, now would be an ideal time for manufacturing to bottom and begin its recovery.
Unfortunately, the ISM Manufacturing index is still making new lows, so on this data alone it is too early to call a cycle bottom yet. However, other manufacturing data points, such as the S&P Global manufacturing PMI, has started to increase from its 2022 lows in most countries – see Figure 3. This hints to possibility that manufacturing may have already bottomed and could now be moving upwards.
Figure 3 – Goods prices should decline further
If this trend continues, equity investors should remain cognisant that cyclical shares tend to outperform defensive shares during periods of rising manufacturing PMIs and thus could benefit from this trend in the coming months.
Labour market is easing while unemployment stays low
Around this time last year, a heated debate broke out between Fed Governor Christopher Waller and former United States Secretary of the Treasury Larry Summers. Summers stated that he believed that it was unlikely that job openings could decline, without leading to a significant rise in unemployment. In other words, Fed Chair Jerome Powell’s hope for a “soft landing” would not work.
Now nine months later it appears that the evidence may prove Summers wrong. The Indeed Job Postings Index shows that job openings are declining without creating increased joblessness. As job openings tend to be a reliable predictor of wage growth, as seen in Figure 4, falling openings and thus wages should lead to lower levels of inflation. If this dynamic continues to play out successfully, the perceived possibility of a soft landing will increase. This should bolster equity markets in the medium term.
AI will benefit more than just the tech industry
AI-linked shares have accounted for almost all of the S&P 500’s year-to-date gains. This was further intensified by the past week’s 30% rally in Nvidia shares. As disciplined investors we are not tempted to chase the latest investing craze.
However, that does not mean that the businesses we have invested in will not benefit from AI innovations. In fact, Goldman Sachs recently estimated that AI could increase the profit margins of businesses on the S&P 500 by on average 4% over the next decade. A result of AI driven productivity gains permeating across many sectors. For example, many businesses would benefit from AI performing repetitive tasks required in the workplace.
AI could help the economy at the ideal time
AI innovations are coming at the ideal time too. The US economy needs faster growth and lower inflation. This is unachievable while the US labour market remains at full employment. With the help of AI technologies, a phase transition in productivity may be possible, boosting economic growth. However, this will depend on how quickly the impacts of AI can be felt.
Despite the AI investment frenzy that has already begun, the productivity impacts are yet to be seen – Figure 5 on the next page. This is typical for revolutionary technological innovations. For example, it took 20 years for productivity numbers to decisively improve after the introduction of the first mass-marketed personal computer, the Commodore PET. And 40 years after the invention of the light bulb for the US economy to become electrified.
If AI follows the same trajectory, we may not see major economy-wide productivity gains until we are well into the 2030s. On the contrary, a major software firm recently provided their customer service workers with access to generative artificial intelligence tools, which led to a 14% rise in productivity shortly thereafter. At this point in time, it remains unclear how long it will take for AI to begin having a material impact on productivity
Figure 4 – Relationship between inflation and unemployment
Figure 5 – AI has yet to impact productivity data
The US economy remains in a “Goldilocks” zone as inflation recedes and unemployment remains low. In turn, equity markets continue to move higher as various economic factors such as a stabilizing housing market and bottoming manufacturing indices act as tailwinds. Looking forward, AI technology is probably a game changer for productivity and not a passing fad, however the benefits are not all immediate. Despite the promising economic outlook in the medium term, we remain cognisant of the probable mild-recession in 2024 and in response continue to de-risk our portfolios.