The stock market continues to climb the proverbial wall of worry with the S&P 500 gaining 1.5% in April after adding 7% in the first quarter. The latest worry is “the end of the dollar dominance” and what it means if the dollar loses its status as the global reserve currency. The story is gaining traction as the U.S. nears the debt ceiling without Congressional approval to raise or suspend the debt limit. Nevertheless, the dollar’s status as the global reserve currency is unlikely to change given a variety of other factors.
If the debt ceiling is hit, the U.S. Treasury does not have the ability to pay its obligations. There is uncertainty surrounding the damage it may cause the economy, but it would certainly be negative. While we don’t know how the Treasury will operate in the event the ceiling is reached, some contingency planning done in 2011 suggests the Treasury would continue to pay interest on Treasury securities and repay principal by issuing new securities at the same amount (thus not increasing overall debt held by the Treasury). The Treasury would then delay payments for all other obligations. Unlike the government shutdown in 2018 and 2019, federal employees would likely continue working. While this is clearly a big unknown risk for the stock and bond markets, the probability of such an event happening is extremely low. This is shown by the credit default swaps for the US government. While they spiked recently, the market is pricing in a small probability of this happening. The increase looks large given the low starting rate, but it implies less than a 1% chance of default.
Investors know there are potential drawdowns and negative developments that will occur. We just lived through a global pandemic that caused a 35% decline in the stock market in a month, a land war in eastern Europe, the fastest rate hiking cycle in Fed history, and yet the stock market has risen at a 9% annualized rate since just before the pandemic started. Our job as investors is to allocate assets to fundamentally strong business and take appropriate risks while accepting the uncertainty that comes along with investing. Accepting some risk is not always rewarded, but doing so without trying to avoid every drawdown in the market has historically been the key to successful long-term investing. Sometimes it just takes a little longer for the risk or investment to pay off.
On a positive note, earnings reports have been much better than expected. With over half of the S&P 500 reporting first quarter earnings, earnings have come in above expectations in every sector. The consensus view was for a 7% earnings decline, but thus far, overall earnings are flat compared to record earnings a year ago. Sales are up in all but 3 sectors with an overall gain of 4%. The best combination of sales and earnings growth is in the materials and consumer discretionary sectors, which is not the typical playbook if anticipating a recession.
Earnings are the primary source of long-term growth in the stock market. Our focus remains on finding high quality businesses, at appropriate valuations, that can grow in various economic, political, or geopolitical environments. An example of why high-quality matters for earnings growth is the recent bankruptcy news for Bed Bath and Beyond. While BB&B will survive in some fashion through a Chapter 11 bankruptcy, the $5.5B in high-quality sales the company generated in the past 12 months is the prize for its competitors. Outlasting your competitors through changing economic environments by having a strong balance sheet can provide additional growth.
The LVM Team