Sources: Congressional Budget Office, WTIA.
Weighing portfolio risks
Investing around geopolitical events, including the debt ceiling, poses a unique set of challenges. A U.S. default falls into the category of a low-probability high-impact event. Even with the negotiating window closing and the Treasury’s X-date approaching, we place low odds on a default—in the range of 10%–15%. However, should a default occur, there would likely be few places to hide outside of cash or gold. We don’t believe a default or downgrade of the country’s debt rating is even partially priced into markets. Despite debt ceiling angst and multiple bank failures, the S&P 500 is now up almost 8% year to date, and investment-grade bonds have returned 2.8% as all but the shortest-term rates have moved lower since the start of the year. (1-, 3-, and 6-month Treasury bill yields are materially higher, reflecting increased risk of a near-term default.)
That said, we believe the best course of action is to remain invested. Odds remain overwhelmingly in the favor of a short-term extension or resolution, in which case any potential volatility between now and then will look like a blip on the radar for a long-term investor. Selling out of the market would generate taxes for many investors, while also adding the dilemma of when to reenter the market. It can, for a number of reasons, be difficult to muster the conviction to deploy previously invested cash back into the market. If a deal is struck as we expect, the market could experience a relief rally in the subsequent days or weeks. We would expect any relief rally to be modest, given the fact that markets have remained resilient in the lead-up to the X-date, but it could still present a situation where an investor is forced to buy back in at higher levels. This can make it tempting to remain in cash indefinitely, particularly if we get more signs of slowing economic growth through the summer.
The current environment may present some interesting opportunities for investors deploying new cash. Typically, when an investor has new money to invest—perhaps from the sale of a business or an inheritance—we advise investing that cash at regular intervals over a roughly 90-day window. (Your advisor can help think through individual circumstances that may necessitate a different plan.) Today, our advice is broadly consistent, but we think it makes sense to be a bit more flexible with deploying new cash. In some cases, it may be appropriate to elongate the investment window from 90 days to no more than 120 days. Or, in anticipation of potential volatility around the X-date and through the summer, investors could put money to work in smaller, more frequent chunks. For example, instead of investing a certain amount every month, investing a smaller amount every two weeks could achieve the same goals while taking advantage of an uptick in volatility. Despite near-term uncertainty, a methodical, timely investment strategy still gives long-term investors the best opportunity to compound returns over a multiyear timeframe.
In the tail-risk scenario of a default, we would expect correlations across equity asset classes and sectors to move closer to 1, with large but potentially short-term losses likely. (The duration of a pullback would be a function of how long after the X-date it takes to reach a resolution, and even in the worst case scenario, we would expect a resolution very shortly after a default.) In our base case where default is avoided, we think the focus of equity investors will quickly shift to the impact of reduced fiscal spending on economic growth. The estimates provided above illustrate the magnitude of the potential short-term hit to the economy, and by extension stocks, which could result from a debt ceiling deal. Headwinds would likely prove greater to more cyclical parts of the equity market. Small-cap equities, which typically exhibit a greater sensitivity to domestic growth, would be expected to underperform larger multinationals. In terms of factors, reduced economic growth and higher recession risks could extend enthusiasm for high-quality stocks exhibiting high profitability and low leverage. We are currently positioned with an underweight to U.S. small-cap equities versus our strategic benchmark and have shifted toward a larger allocation to high-quality equity strategies since the start of the year.
The risks around the debt ceiling are uncomfortably high—around 10%–15% risk of a default—while the shrinking timeline to strike a deal is increasing the urgency in Washington. Even in our base case of a resolution, the devil will be in the fiscal spending details, and a deal that favors the current Republican position could weigh more heavily on short-term prospects for the economy and cyclical equities.
Within a fully invested portfolio, we are already taking a more defensive posture with an above-benchmark weight to cash and investment-grade fixed income. We are underweight equities versus our strategic benchmark across U.S. small cap and international developed. This defensive positioning is due in part to debt ceiling risks but can mostly be attributed to our expectation for a U.S. recession in the second half of 2023—even without dramatic spending cuts from Congress. We expect an economic contraction to be short and shallow, but it could be worsened by higher levels of spending cuts. If our recession forecast comes to fruition, we expect U.S. large-cap equities to move lower, which could provide an opportunity to move back to a neutral or even overweight allocation to equities as we position for the next multiyear bull market.