“Forget About Recession, Forget About Inflation Or Banking Turmoil, Forget About A Last-Minute Breakdown In Debt Ceiling Talks”

By Elwin de Groot, Head of Macro Strategy at Rabobank

Ain’t it all coming along nicely?

US and European equity markets are playing true to their innate love (or bias?) for optimism. The S&P500 index just reached its highest level since August last year, European equities are already way beyond that mark, although they are still slightly trailing their month-ago levels. Forget about the upcoming recession, forget about persistent inflation or the US regional banking turmoil, and let’s not think of a last-minute breakdown in the US debt ceiling talks.

It would be foolish to simply discard this as irrational or wrong and to ignore what equity markets are trying to tell us. So what are they telling us?

First of all it seems that investors are less concerned about fundamentals. The long-awaited recession in both the US and the Eurozone still hasn’t come to pass and although (non-energy, non-financial) corporate margins have shrunk over the past year or so, things have not been as weak as expected. Including the energy sector would only strengthen the conclusion that profitability has been upheld. In fact, the most recent earnings season has overwhelmingly surprised to the upside, both for earnings and sales. And for those with a longer-term perspective, there is always the new AI revolution to cling on to.

Secondly, with central banks having slowed their pace of rate hikes, the market has concluded that the end of the tightening cycle may be near and it seems willing to accept the near-term uncertainty that is usually tied to that pivot point. Even though we don’t agree to this optimistic reading of the tea leaves, with long-term rates essentially having moved sideways (or down on balance in the US) over the past several months, the higher rates environment clearly has not proved a major impediment to a more positive risk sentiment of late.

One often overlooked aspect, though, is the liquidity environment. For example, the Fed’s Bank Term Funding Program, which was one of its key responses to the regional banking turmoil, injected some $400bn net into the system, partly offsetting the decline in the Fed’s balance sheet that had started in 2022 with the unwind of its asset purchase program. Although the use of this facility has on a downward path again in recent months, the size of the Fed’s balance sheet is not back to the pre-banking turmoil levels yet. Meanwhile, with the looming debt limit, the US Treasury has been taking all sorts of measures to avoid breaching the $31.4trn debt cap. Data published yesterday showed that the Treasury’s cash balance dropped to $68.4bn; last week it still stood at $140bn. By limiting its supply of securities to the market, the Treasury may have contributed to a more sanguine rates environment (except for the very short-dated T-bills) as well. But, barring a default, this is obviously a temporary phenomenon.

Although I am not so much raising the point of whether equities are overvalued or not, I want to highlight that this backdrop described above may also be behind a fairly favorable reading of the risk environment. This, potentially, is a bigger issue. Let’s take the G7 meeting, the hopes for a US debt ceiling resolution and liquidity as three examples.

Today marks the official start to the G7 meeting in Hiroshima. But in the run-up to this meeting we have already seen a flurry of comments and pronouncements by world leaders, including some very concrete developments. The first key objective is that this G7 is clearly all about presenting a ‘united front’ against Russia, and against other countries that are not following the West and/or are trying to break away from the US-polarity. There appears to be a strong commitment by the G7 to support Ukraine and tighten the economic noose on Russia. Sanctions will be broadened to a wider group of goods, especially those that could facilitate Russia’s war effort. According to Bloomberg, the latest draft of a statement does not talk about a near outright ban on exports to Russia, though. Meanwhile, existing sanctions will be tightened by removing loopholes to circumvent them. This would include the strengthening of enforcement in regards to third countries through which Russia is importing banned goods. One key risk here is that the G7 (plus ‘coalition of the willing’) drive a wider gap between them and those countries that have taken on a more ‘neutral’ stance in the matter. The EU’s Borrell’s call for action against Indian refined products made from Russian oil is an example here, as it has drawn a stingy response from India, who argues that such a measure would even be inconsistent with the EU’s own regulations. Although Japan’s PM Kishida has, amongst others, also invited India, Indonesia and Brazil, I’d imagine these nations would not like to return home empty-handed.

The second key objective of the summit is for the G7 and friends to get a better grip on reducing vulnerabilities in supply chains, in particular on dependency on single economies, such as China. On that front, there has been some concrete news on the sidelines, such as the deal between US-based semiconductor designer and manufacturer Micron Technologies and the Japanese government on a USD1.5bn incentive to develop next generation memory chips in Japan, with Dutch ASML’s EUV technology, as Bloomberg reported yesterday. UK Prime minister Sunak announced GDP18bn of new investment by Japanese firms in the UK, including a semiconductor partnership. So, small steps are being taken. But on the ‘build back better’ front, we would argue that there is really so much on the TO-DO list that expectations may simply be too high and divisions within the G7 (and EU) remain considerable. The way French president Macron wants to go forward, is not necessarily supported in all corners of Europe, even though he is probably one of the few leaders that actually has a clear and stated view.

Turning to the other elephant in the room, the US debt ceiling talks, there has been some positive news yesterday. Notably, it was House Speaker McCarthy that sounded the most optimistic since this saga started. McCarthy said that “he thinks an eventual debt limit bills needs to be on the floor next week, they are not there yet but he sees the path, they are in a much better place than a week earlier and it is important to have an agreement in principle this weekend”. Meanwhile Senate leader Schumer said that negotiations are continuing in the right direction and the Senate would act right after a house vote on the debt limit.

Of course, it ain’t over until the fat lady sings (or the actors in this game of chicken are back in their cages), but if we assume for a moment that there will indeed be an agreement before the Treasury truly runs out of cash, this would also imply a green light for a flurry of fresh debt issuance and hence a withdrawal of liquidity from the market. More fundamentally, although more Fed hikes isn’t our base case (we do expect the Fed to stay on hold longer than the market expects, though), such a deal may at least remove one potential impediment to further rate hikes by the Fed, should that be necessary. In the face of persistent inflation that is obviously not such an outlandish alternative scenario.

Finally, we note that we are only little more than a month removed from the repayment of a considerable sum of EUR477bn by European banks to the ECB. Bloomberg reports this morning that the ECB is “stepping up scrutiny of lenders’ liquidity reserves and may communicate stricter requirements to individual firms later this year […]”. Such measures would reduce the amount of ‘free’ liquidity on top of the impact from TLTRO repayments and a gradual wind down of the APP. In other words, if anything, the liquidity environment going forward could become less favorable for risk appetite.