Our previous market update letter highlighted the debt ceiling as the most recent risk, among many others, that is on investor minds. Thankfully, the political theater is over and an 11-th hour bill was passed to increase the U.S. debt ceiling. The agreement was a compromise and required a bipartisan vote in congress to pass with opposition from certain factions from both parties. The bill will suspend the $31.4 trillion debt ceiling until January 2025, holding nondefense spending in fiscal year 2024 at similar levels to 2023 and allowing for a 1% increase in 2025. The budget limits are seen as somewhat symbolic as the Congressional Budget Office’s baseline projections are for $20 trillion in new government debt over the next decade. Analysis of the bill suggests this agreement won’t change that figure considerably.
So, what does this mean for the capital markets?
· The agreement should prevent U.S. Government credit downgrades. Ratings agencies put the U.S. on credit watch a few weeks before the bill was passed. The last credit downgrade of U.S. debt in 2011 caused broader market indices to fall between 5% and 7%.
· The passing of the debt ceiling may also give the Federal Reserve room to raise interest rates another 25 basis points on June 16th if inflation and employment data (the May jobs report showed continued strength in the labor market) remain strong.
· Treasury-bill sales from the U.S. Government are expected to rise to cover deficits which could put more pressure on interest rates and increase cash flows out of bank deposits into treasuries.
· Higher rates over the past 15 months have put a tailwind behind the U.S. dollar (interest rate differentials and growth are the largest impacts to currency swings). This impacts large U.S. multination companies’ foreign currency revenue and earnings that are translated back to U.S. dollars. This may be offset by international investors risk premium required on the U.S. Dollar given future debt issuance by the U.S. government.
While these and other impacts related to the debt ceiling will take time to work themselves out, the initial reaction from the overall stock market has been positive. That’s if you own the top 10 stocks by market cap in the S&P 500. The top 10 stocks have accounted for almost the entirety of the market’s 9% return year-to-date through May. Our chart below shows the return difference between the S&P 500 market cap weighted total return versus the S&P 500 equal weighted total return. While the S&P 500 has a positive 9% return the equal weight index is negative for the year.
Less than half of the stocks in the S&P 500 are positive for the year with a median stock return of negative 1.85%. The performance discrepancy of the largest stocks can partially be explained by their strong balance sheets, long-term growth expectations, and premium profit margins, but growth in their valuation multiples has provided additional support. The chart below shows the top 8 stocks in the S&P 500 have a forward price-to-earnings ratio (P/E) of 29.6. This compares to the entire S&P 500 (which includes these top 8 stocks) P/E ratio of 18.5 and small and mid-cap stocks forward P/E ratios near 13.3. These small and mid-cap companies may not have the same profit margins, balance sheet strength or the growth expectations as some in the top 10, but as we always say “Value and growth are two sides of the same coin. A stock is not a good value if there is not some underlying growth, and a growth stock is not a good investment if you pay too high a price.” Finding the right valuation to pay for profitability, growth, and quality is what we strive to achieve in our investment research.
As a reminder our 35th anniversary party at the Air Zoo in Portage will be held on Thursday June 29th from 6:00 PM to 9:00 PM. We would love to see you there, please send an RSVP to lcrawford@lvmcapital.com if you will be able to attend.
Comments