Debt ceiling crisis is receding

In stock markets, at least one risk is receding after a deal on the debt ceiling crisis was reached over the weekend.

I’ll also mention briefly, the Swedish real estate market is under increasing pressure from rising interest rates. SBB, a major real estate investor, is going through a restructuring partly through property sales or by cutting itself up into pieces. This means that potentially €12 billion worth of mainly care properties are coming up for sale in the Nordic countries. A share issue was no longer an option, as investors did not have any taste for that. The real estate company has €7 billion in debt. I'm sure the banks will get their money back, but the company's collapse illustrates the plight of indebted companies in a crumbling market.

In this post, we talk about the debt ceiling crisis receding and the resilience of the US economy.

The debt ceiling crisis is receding

The debt ceiling crisis seems to be receding, as over the weekend Biden and Republican McCarthy reached a preliminary understanding. Thus, at least one risk will disappear behind the scenes from disrupting the stock market.

The debt ceiling increase is accompanied by a compromise package that freezes the growth of public spending in the near term, except for defense, and does not raise taxes. The Inflation Reduction Act that is aimed at accelerating the green transition and includes billion-dollar subsidies was not touched upon. The act could benefit Finnish companies such as Wärtsilä and Kempower.

Both sides can now happily declare a political victory and the country's default has been heroically averted.

The debt ceiling will be put on the shelf for a while, and we can look forward to a new thriller in 2025. In the market, the cost of hedging against a US default was higher than in the 2011 debt ceiling crisis. Judging by the political polarization, these moments of tension are unlikely to subside in the future.

The debt ceiling package must be approved by Congress, so it's not worth counting your chicks before they hatch.

The bottom of the Treasury general account started to show last week, so the raising of the debt ceiling comes in the eleventh hour. The next question is how much liquidity replenishing the account back to "normal" levels to some hundreds of billions will suck from the market. After all, the federal government has to issue bonds, and the money invested in them doesn't go into equities, for example.

One reason why equities have been reasonable lately is that liquidity has improved. It’s therefore a good question to ask what kind of headwinds will blow into equities when the liquidity trend turns downwards due to the filling of the current account.

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Inflation is persistent and consumption is roaring

Let's take a look at inflation and consumption in the US, the world's economic powerhouse. Data that's lagging a bit behind was released on both on Friday for April, but the main message is that neither is showing a significant slowdown.

Core inflation of private consumption, i.e., inflation excluding volatile food and energy costs, has stagnated at an annual rate of 4.7%. At monthly level, prices also rose faster than expected. Although the change in the price of consumer goods has collapsed, the economy is largely made up of the services sector, which shows little sign of cooling.

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More evidence of strength in the services sector came last week when the latest Purchasing Managers' Index data for May showed an acceleration in spending, while in manufacturing the reading was below 50, indicating a decline in activity relative to the previous month.

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In the US, household consumption accounts for about two-thirds of the total economy. And there is no sign of slowing down. In nominal terms, consumption continued to grow at an annual rate of almost 7% in April. Consumption is also growing in real terms, as that growth rate is faster than inflation. In this graph, recessions are marked with gray bars and, as you can see, this measure does not predict recessions well and consumption may still be growing at the onset of a recession. In fact, in the macro-economy, recessions are often only noticed after they have been going on for some time. In other words, this data is like looking in the rear-view mirror for the equity investor, but it reinforces the picture of an economy that was strong at least until just a moment ago.

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This will not necessarily change immediately either, because strong wage growth will enable sustainable consumption, which the economy's production capacity and the number of hand-pairs cannot quite match, feeding the rise in prices. Household disposable income is growing at an annual rate of 8%. If the rise in the last three months is annualized, the increase is still 5%. These figures are above inflation, meaning that real household income is developing positively. On one hand, strong wage growth feeds inflation, but on the other, it enables a strong economy. The US labor market is showing no signs of weakness so far, so wage growth is unlikely to stall overnight.

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No party lasts forever, but this one seems to have good ingredients in the punch bowl.

One factor that could dampen consumption towards the end of the year is the dwindling of extra household savings. According to a recent study by the San Francisco Fed, there are still 500 billion in extra savings, and at current rates they will run out by the end of the year.

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As many of you know, the massive public stimulus and checks directly into people's current accounts during the pandemic significantly strengthened household balance sheets. Indeed, the recovery during the pandemic was exceptionally generous, with public spending rising by 35%. In previous downturns, the rise has been in the ballpark of 5-10% in general.

The savings dynamics of the short duration of the pandemic recession are also quite exceptional compared to a normal recession. This graph underlines the bizarre nature of recent times. Generally, in recessions, savings rise slowly as households become more cautious and cut down on their spending. Saving up, of course, is part of the reason for recessions in the first place, because one person's spending is another person's income and cutting your own spending directly hits someone else's wallet. But in this miracle age, the rapid expansion of savings has been followed by the rapid consumption of savings.

No wonder, then, why the economy has been so strong.

According to the researchers, the cumulative amount of extra savings left in the pockets of households was $2.1 trillion, of which $1.6 trillion has now been spent and $500 billion remains. If the current pace continues and there is no change in households' saving behavior, the extra savings will have been used up by the end of the year as I mentioned. It will be interesting to see what happens to the economy and inflation when this extra tailwind comes to an end. On top of that, the hands of the public sector are now tied by the debt ceiling deal.

Despite the persistence of inflation, I continue to raise the point that it no longer seems to plague the market. Stock markets, and in particular interest-sensitive technology stocks, have been on a strong run recently. The spearhead of the AI hype, NVIDIA, has surged to new all-time highs closer to a market capitalization of one trillion, although the stock's valuation multiples seem high. In general, the rallying of tech shares has sparked talk of a new tech-bubble, but we won't get into that theme this time in this post.

With a strong economy, expectations of a quick cut in the Fed’s policy rate have been scrapped. At the moment, there is a small possibility that the market could still raise the policy rate to 5.5% in the summer, and the rate would not start to fall until next year.

After the banking crisis in the spring, interest rates have started to recover, and the US 10-year bond is back within a stone's throw of 4%. The rate on this bond can be seen as a kind of gravitational force for equities, but we must also remember that interest rates reflect not only inflation but also the economic growth outlook.

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If inflation does not surprise on the upside in a negative way, while the economic downturn remained the technical recession of the first half of last year, higher interest rates also signal the possibility of more buoyant earnings growth in the future. Thus, equities and high interest rates can co-exist for the time being. Perhaps at some point we will return to the old worry of how long the economy can sustain high interest rates until something eventually breaks down.

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