“Latest activity readings point to solid underlying growth momentum while debt ceiling concerns looms”

Macro

The Treasury debt limit, also known as the debt ceiling, is the maximum amount of debt that the Treasury can issue to the public or to other federal agencies. The amount is set by law and has been increased or suspended many times over the decades to allow the Treasury to finance the government’s operations. Over the past century, the US has raised its debt limit more than 90 times (nothing new), it currently stands at ~32 Trillion USD.

Many may not know, but the debt limit was actually hit on January 19, and the Treasury is now using “extraordinary measures” to come up with the additional cash needed to pay its bills. Based on experts’ assessment of the government’s outlays and receipts in coming weeks, those measures seem likely to be exhausted by early June (X-date). Expectations are that lawmakers will suspend or increase the Treasury debt limit before this happens, allowing the Treasury to issue more debt and pay the bills.

Next, we are going to discuss the most likely scenarios that could happen:

1. Clean Debt increase:They pass legislation to increase the debt limit just before the X-date, and the Treasury is able to pay all of the government’s bills on time. The legislation does not include any meaningful changes to fiscal policy and is thus a so-called clean debt limit increase.
2. Republican’s plan: Lawmakers avoid a debt limit breach by agreeing to adopt the government budget cuts recently proposed by House Republicans. (spending cuts/budget reform etc.)
3. Constitutional Crisis: We assume that lawmakers are unable to reach agreement, and with a debt limit breach imminent President Biden invokes Section 4 of the 14th Amendment and orders the Treasury to keep issuing bonds and paying the government’s bills.
4. Payment prioritization: A more worrisome scenario is that the debt limit is breached, and the Treasury prioritizes who gets paid on time and who does not. The department almost certainly would pay investors in Treasury securities first to avoid defaulting on its debt obligations.
5. Prolonged breach: This leads to the worst-case scenario. In it, lawmakers breach the debt limit and trigger a relief program but fail to respond and immediately reverse course but instead, the political impasse drags on for weeks/months. We assume in these circumstances that the credit rating agencies would downgrade Treasury debt, precipitating widespread downgrades throughout the financial system.

The debt ceiling impasse of 2011, which triggered the loss of the US government’s AAA rating from S&P, offers a cautionary example for today. In the weeks following the downgrade in August 2011, US stocks fell by double digits and Treasury yields slid sharply (albeit the risk-off move was also compounded by the peripheral debt crisis in Europe). Congress increased the ceiling just before the X-date, the closest call on record. Market pricing of US default risk is now higher than it was during the 2011 debt ceiling standoff, as reflected by elevated spreads on US Sovereign credit default swaps.

In all scenarios except one where there is a clean increase in debt ceiling, both GDP and employment is expected to fall by varying levels. Like in prior instances of debt ceiling drama, volatility will be heightened, but it also tends to be short-lived. For many investors, the best defense may be to stick to core portfolios and position defensively.

In the extreme scenario that the US actually defaults, hedging would be key under this scenario. Risk assets would get hit the hardest. Gold, structured notes with deep downside protection, and other safe haven currencies like Swiss Franc, Japanese Yen, or Euro may provide some portfolio protection.

The potential for a disorderly debt ceiling episode provides another opportunity for global investors to reconsider their portfolio allocations across asset classes and regions. Bonds still provide compelling income and protection. For those sitting on excess cash, debt ceiling turbulence could be a good thing to watch for a potential entry point.

Fixed Income Macro

Bond yields are rising on firmer data and anticipation of a surge in Treasury issuance as markets price a timely resolution to the US debt limit. The latest activity readings point to solid underlying growth momentum reinforced by May’s US Composite PMI at 54.5 vs 53.4 the prior month. US Core PCE quarter-on-quarter increased 5%. Yet the FOMC is potentially pausing hikes in June on several considerations. First, the lagged effects of tightening in policy rates so far. Second, perception of financial stability risks associated with moving at a steep pace, with emergence of US banking sector stress and tightening in bank lending. Third, expectation that policy is now sufficiently restrictive to ensure that inflation moderates from here.

On the US debt ceiling, the clock is ticking with Treasury likely to exhaust resources under the debt limit by early June. The most likely outcome is raising the limit before a technical default can occur, though currently the timeframe for Congress to approve the deal is tight, so downside risks are not completely nil. As the deadline approaches, market focus is on the potential impact of a resolution. If, as expected, the debt ceiling is lifted or suspended, Treasury is expected to increase T-bill issuance up to $750 billion during 3Q23 to replenish its cash balance. In the unlikely event of a default, expect bonds yields to decline sharply as markets price in Fed easing while credit spreads widen on financial stability concerns.

In China, weaker than expected industrial production, retail sales and fixed asset investments suggest economic momentum is waning. April IP rose 5.6% year-on-year vs 10.9% consensus. On domestic demand, retail sales rose 18.4% year-on-year vs 21.9% consensus. FAI was weaker than expected, rising only 4.7% year-on-year in April vs 5.7% forecast. Additionally, the youth unemployment rate surged to a record high of 20.4%. With lack of evidence of an immediate rebound, this is raising some questions on the China reopening narrative that was a big driver of the market in the early part of the year. The government’s conservative 2023 growth target of 5% and focus on curbing financial risks allows the PBOC to be patient on monetary policy easing, with expectations that during 2Q23 the loan prime rate and banks’ reserve requirement ratio are maintained at 3.65% and 10.75% respectively.

China Industrial Production and Retail Sales Sliding

Source: Bloomberg Finance L.P.

Fixed Income Strategy

Reflecting increased Treasury supply expectations from debt ceiling resolution and core PCE coming in above consensus, 2-year and 10-year Treasury yields rose month-to-date by 56 bp and 37 bp respectively, bringing both modestly above post-March ranges. If debt limit legislation is accompanied by reduction in federal spending, the fiscal outlook may be perceived as having further tightening effects. In the unlikely event Congress fails to pass the deal by the time Treasury exhausts its resources, the adverse effects of a technical default on T-bills and higher recession probabilities being priced, makes it more likely that long dated Treasury bonds rally. Taken together, extend rates duration in bond portfolios.

Asia credit spreads have been broadly flat since the March banking sector turmoil. We maintain preference for investment grade on expectations that the higher quality segment should be more resilient in the face of macro headwinds and more volatile markets. Credit stresses continue to be evident in China property high yield, curbing market appetite for riskier issuers. Having said, technicals should be supportive of better credits, as new issuance volume remains subdued. Overall, the expected direction of spreads is towards widening in case of a breakout from the range, with liquidity drain triggered by debt ceiling resolution the likely catalyst.

We are inclined to increase position in Macau gaming operators. Takeaway from the first earnings since reopening is better than expected gross gaming revenue recovery. Considering the 1Q23 constraints in transportation and hotel capacity from labour shortages, this bodes well for further recovery as bottlenecks should ease from here. S&P projects Macau mass GGR to recover to 75-85% of 2019 levels this year and to fully recover by 2024, while assuming VIP GGR in 2023 to remain at about 20-25% of 2019 levels. Most operators are expected to start generating positive free cash flow net of investment commitments per condition for concession renewal, allowing leverage to trend lower. With sector spreads backing up 10 – 20 bp month-to-date, and yields at 8% and above, valuations are somewhat more attractive.

Equities Strategies

As it is, we believe the odds of a mild recession by year-end has risen, but the potential and timing of any rate cut is still unclear at this juncture. Our view is that the probability of any rate cut this year is currently low as key macro data such as a strong labour market and consumption are still holding up and the US banking sector turmoil hasn’t really spread to other sectors. This is in contrast with the futures markets, where it is pricing in three rate cuts by January 2024. Amid this uncertainty as well as the increasing odds of a recession, we prefer to position defensively. Thus, we continue to be advocates of defensive sectors in US equities, ie. consumer staples and healthcare and concurrently seek opportunities to implement shorter-term tactical/swing trades through accumulating or buying quality, high beta US names such as blue-chip technology stocks as investors sector rotate into higher beta names in view of a potential end to rate hikes and a likely resolution of the debt ceiling.

For HK/China, we continue to remain overweight in beneficiaries of the China reopening theme despite the slower-than-anticipated “reopening” thus far; Chinese airlines, domestic consumption-related, travel-related and F&B-related sectors. We are also skewed towards infrastructure-related names in view of an accommodative policy stance to support the domestic economy. These sectors are currently trading at attractive valuations post recent declines and deserve our attention be it from a longer-term fundamental perspective or that of a short term swing trade. We continue to be advocates of defensive sectors such as Telecoms and Utilities that provide reasonable dividend yields and valuation upside.