A debt ceiling deal, but the rally needs more

Deep Dive video: The 2023 private market outlook (7:38)
CIO’s Karim Cherif has the playbook for private markets into 2H23.

Senior Republican House lawmakers on Monday began the process of advancing the Biden-McCarthy debt-ceiling compromise deal to a broader House vote, as leaders in both parties seek to raise the debt ceiling for two years and avert a US default. The in-principle deal announced by US President Joe Biden and House Speaker Kevin McCarthy on Saturday must clear both the House and Senate, with lawmakers facing a revised 5 June X-date deadline from the Treasury to get a deal done.

With US markets closed on Monday for Memorial Day, S&P 500 futures are up 0.25% and gold prices have eased slightly. Having mostly advanced on Monday, Asian equities edged lower Tuesday, while the 10-year US Treasury yield fell 2bps to 3.75%.

While the prospect of a resolution this week is positive for risk sentiment and may support stocks in the near term, we still think the risk-reward balance for broad US equities remains unfavorable amid other macro challenges.

The Fed’s next move is less than certain. Earlier this month, markets were pricing in a near-zero probability of an additional Fed rate hike, but this has changed significantly, with a hike by July now fully priced in. Recent economic data coming out of the US has been more resilient than expected, and the latest personal consumption expenditure (PCE) prints showed that consumer demand is still holding up. Both the headline and core PCE indices rose 0.4% m/m in April, with personal spending (at 0.8%) above the consensus forecast and wage income up a solid 0.5%. Core PCE inflation rose 4.7% y/y, still far above the Fed’s 2% target. While Fed Chair Jerome Powell appeared to be considering a pause in the central bank’s most aggressive tightening cycle since the 1980s, he has stressed the importance of incoming data and that assessments will be made “meeting by meeting.”

The debt ceiling deal may add to US growth headwinds. Details of the debt ceiling deal emerging so far point to spending limits on most items other than military and veterans, meaning the US economy will be facing greater restraints to fiscal policy while the Fed pursues a tight monetary policy. According to minutes from its latest policy meeting, the Fed has already had a recession in its baseline projection, with real GDP contracting in the final quarter of this year and the first quarter of next year. We reiterate our view that US growth is set to slow as the lagged effect of Fed tightening feeds through into the economy amid stricter lending standards from banks.

Equity valuations remain elevated, with exceptionally narrow breadth to the rally. The S&P 500 forward P/E of 18.5x is at a roughly 14% premium to its average over the past decade, reinforcing our view that the near-term upside for equities remains limited. In addition, the outsize year-to-date gains of the NYSE FANG+ index (60%), which tracks the top 10 most traded tech companies, underscore how narrow the rally has been this year. The market-cap-weighted S&P 500 has risen 9.5% year-to-date, but on an equal-weighted basis—which dilutes the impact of mega-cap stocks—the index has fallen 0.4%. Historically, narrow leadership has been a hallmark of late-stage bull markets rather than the start of a more prolonged upswing.

So we continue to prefer bonds over equities in our global strategy, favoring defensive, higher-quality segments of fixed income, as they offer both attractive absolute yields and a hedge against growth and financial stability risks. Within equities, we recommend utilizing high-dividend and quality stocks to add income. We also think the recent haven flows into the dollar should reduce, and we continue to see gold as an effective portfolio diversifier and hedge.