X marks the spot
The US debt ceiling drama that has been unfolding has been the subject of many headlines over the past few weeks. But, what is the debt ceiling and why is there a standoff? The debt ceiling is essentially a limit on the amount of debt that can be borrowed by the US Treasury. The US government issues bonds to sell to investors around the world to meet its obligations such as paying social security benefits, interest on its current national debt, and so on. Currently, the ceiling stands at about US$31.4 trillion, and the US hit this limit in January 2023.
The US Treasury Department has now resorted to “extraordinary measures” to continue meeting the US’ obligations. This means it is now running down its cash balance until there is none left. How long the cash balance will last is hard to determine. Janet Yellen, the US Treasury Secretary, has remarked that the X-date — which is when the US is no longer able to pay its bills — could be as early as 1 June 2023.
Given that the debt ceiling is entirely self-inflicted by the US, why is it so difficult to reach an agreement to increase this artificial (and arbitrary) limit? The Democratic party currently has control of the US Senate while the Republicans are in control of the House. Democrats want to raise the debt ceiling without any conditions attached, but Republicans want spending cuts to food stamps, government aid, and renewable energy tax breaks in order to raise the debt ceiling. With neither party willing to concede, they have now reached stalemate.
Will the US default on its debt?
The US has never had a default. But we’ve seen this show before — many times, in fact. The debt ceiling has been increased 102 times since World War II. However, the situation is made much worse when the Senate and the House are each controlled by different parties. The most recent and perhaps most relevant episode occurred in 2011 when the ceiling was raised just two days before the X-date. The US federal government’s credit rating was then downgraded from AAA to AA+ by a major credit rating agency.
If the debt ceiling is not raised in time, the risk of default could increase exponentially. The impact to the US and global economy could be catastrophic, even though the US would eventually be able to meet its obligations. There are some who argue that the US Treasury and the government could find ways to mitigate the potential fallout, but no one can clearly predict how that would play out.
In 2011, we saw the S&P 500 index decline by about 19% from the peak in April 2011 to the trough in October 2011. By February 2012, the US market had bounced back up to its level in February 2011.
The two main takeaways from history are:
- Policymakers have generally come to a compromise in order to prevent an economic catastrophe, and
- The impact may be more limited and transitory in nature.
Market reactions to the drama
Even with the brouhaha around the US debt ceiling saga, the CBOE Volatility Index, or VIX, has been lying low.
As we draw closer to the X-date, short-term US Treasury bills with a maturity date around or after the X-date have seen their yields increase. However, yields on longer-dated Treasury bonds remained largely unchanged.
Aside from T-bills, there was significant movement in credit default swaps (CDS) on US debt as the cost of insurance on US debt spiked.
With diversification, long-term investors can rest easy
Most analysts and market experts believe the risk of a US debt default is very low. The situation becomes less bleak and more manageable if you look at the average expected outcome of possible scenarios encompassing a resolution to the US debt ceiling issue and a catastrophic default, and taking into account all the probabilities.
Moreover, even in the unlikely outcome of a technical US debt default, we believe the impact may be short-lived as we have seen with other global events in history. A study of bear markets and subsequent recoveries from the 1800s to early 2020 by Goldman Sachs Investment Research showed that the average event-driven bear market tended to last no more than 10 months, and took fewer than 20 months to recover.
Diversification, diversification, and diversification in all aspects is most likely the best defence against uncertainty. If your risk tolerance and risk appetite allow for it, making sure you have both equity and fixed income in your portfolio could help.
For Professional Investors in Hong Kong, you can also consider adding alternative investments for further diversification in your investment portfolio. Endowus has a private wealth arm that provides access to alternative investments including hedge funds, private real estate, private equity and private credit strategies. For more information, contact us for a consultation or email us at privatewealth.hk@endowus.com.
Read more: Understanding alternative investments
April market commentary
To wrap up, here is a summary of April 2023 market performance.
Both the global equity and the fixed income markets had a positive month in April 2023, albeit a small gain. The MSCI All Country World Index (net div, USD) rose 1.4% while the Bloomberg Global Aggregate Index (USD, hedged) gained 0.5%.
The best-performing region for the month was Europe. The MSCI Europe Index (net div, USD) posted a 4.1% gain, the S&P 500 rose 1.6% and the MSCI AC Asia Index (net div, USD) fell 1.2%. Gross domestic product (GDP) data showed that the eurozone economy grew by about 0.1% after being flat in the fourth quarter of 2022. The aggregate eurozone GDP growth figure was boosted by relatively strong expansion in Spain and Italy. In the UK, financials was one of the top performing sectors for the month as fears around the banking crisis receded somewhat. The March inflation number was higher than January’s, adding to speculation that the Bank of England may have to increase rates again to tamper inflation.
The US had a lacklustre month as weaker economic data weighed on investors’ minds. The collapse of First Republic Bank and its subsequent acquisition by JP Morgan caused some uneasiness, but the markets digested and took the news in stride. The Fed raised rates again in May, by another 25 basis points, but signalled that it might pause on subsequent hikes.
Emerging markets, as a region, retracted 1.1%, underperforming the developed markets by about 2.9%. The weak performance was largely due to China, falling more than 5% in April. The renewing of US-China tensions was one factor contributing to the decline.
In a reversal from March, value stocks made a comeback and outperformed growth stocks during the month of April. Global large-cap stocks continued to outpace small-cap stocks.
In fixed income, bond returns were generally flat after the rally in March because of lower bond yields. Credit markets were generally positive in April.
The S&P GSCI — a benchmark for investment in the commodity markets — saw a small decline of about 0.8% in April as agriculture, energy and industrial metals posted negative returns. Crude oil and gold rose modestly for the month.
Building a long-term resilient portfolio with Endowus Fund Smart
It is almost impossible to predict exactly how macro events would play out. However, spreading your investments across asset classes and geographies will help with diversifying your risk. With market volatility comes opportunities. If you have a long-term investing horizon, as many of us do, these developments may offer an opportunity through steady, regular investing in diversified and risk-adjusted portfolios.
With digital wealth platform Endowus, you can plan and manage your money — by investing in Best-in-Class Funds and globally diversified, intelligent, low-cost funds and portfolios seamlessly.
Click here to get started with your investing journey with Endowus Hong Kong today.
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Read more:
- Introducing Endowus model portfolios — curated with Best-in-Class Funds for core-satellite strategies
- Why invest through Endowus
- Introducing the Endowus HK team
- Choosing Endowus when investing in Hong Kong
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