Markets Continue Tentative Recovery

Nick Levinson Comments, Life with Money

Stock and bond markets worldwide continued to recover from the declines of 2022.

Bonds (as measured by the Vanguard Total Bond Market index fund) dropped more than 13% for the full year, but rose 3% in the fourth quarter of 2022 and almost 2% in January.
US stocks (as measured by the Vanguard Total US Stock Market index fund) fell more than 19% in 2022, but gained almost 7% in the fourth quarter of 2022 and another 7.1% in January.

International stocks exhibited a similar pattern: Developed country shares (as measured by the Vanguard Developed Country Stock index fund) declined more than 15% last year, but rose almost 9% in the fourth quarter of 2022 and another 17% in January. Emerging markets stocks (as measured by the Vanguard Emerging Markets Stock index fund) declined almost 18% in 2022, but gained almost 8% in the fourth quarter of 2022 and another 8% in January.

The eternal question is whether these gains will hold and possibly even continue. Only time will tell, of course, but we do want to note several ongoing areas of economic uncertainty.

Significant issues remain

The recent stock and bond market gains appear to have resulted largely from reduced inflation around the world. The Consumer Price Index declined from over 9% in mid-2022 to 6% in January, caused at least in part by interest rate increases from the US Federal Reserve. These increases have raised the cost of borrowing for businesses and consumers and slowed the pace of hiring along with real estate prices and other key economic indicators.

“Price increases are beginning to cool notably, and Fed officials have slowed their rate increases as they wait to see how their cumulative changes are affecting the economy after a year of rapid adjustment.” Investors are “now waiting for clarity on how high officials will push borrowing costs, and how long they will leave them elevated, to ensure that inflation comes back fully under control” (The New York Times).

While a strong US jobs report in January reduced some concerns of recession, it also re-ignited fears of ongoing inflation. “Employers hired ravenously in January, adding 517,000 workers. The jobless rate dipped to a level not seen since 1969, and revisions to last year’s data showed that job growth was even stronger in 2021 and 2022 than previously understood.”

Other labor market data further complicated the outlook. “Still, the gradual rebound in the number of people working or looking for work, and the fact that pay gains have been easing as the jobless rate has plummeted, could make some Fed officials question whether they need to slow down the job market as drastically as they had expected. It is possible that a rebounding supply of workers could help fill open positions, allowing the economy to reach a more even keel in which wages gently cool without major job losses.” This would be the proverbial “soft landing” that investors hope for, but more data appears necessary to confirm the trend.

Debt ceiling jitters

Another major cause of the current unsettled environment is the possibility of a default on US debt. This is the “debt ceiling” issue, which stems from the fact that Federal spending authorized by Congress needs to be funded by some borrowing, since tax revenues cover only about 80% of total expenses. The current maximum debt is $31.4 trillion, a limit that Treasury Secretary Janet Yellen says was breached in January. She appears to have flexibility to continue payments through spring 2023, but without an agreement to raise the debt ceiling before then, the US might not be able to pay bond holders and Social Security recipients, among others.

Unfortunately, we’ve been here before. “The last close call, in 2011 when … Joe Biden was Vice President, was resolved with only days to spare, spooking stock markets and leading one bond rating agency to downgrade the federal government’s credit” (The Economist). More recently, “when Donald Trump was President, the debt ceiling was increased three times with Republican support, and the national debt rose by $8 trillion over his term ($3.2 trillion of which came before Covid-induced spending began in 2020).” Now, with divided government back in Washington, the two sides appear to have reached an impasse. President Biden argues that the debt ceiling must be raised without conditions to pay for previously-approved spending, while House Republicans are demanding unspecified spending cuts in return for support in lifting the ceiling.

Given this deadlock and the economic chaos default might cause, economists and policy makers have been searching for potential workarounds. The Economist article cited above mentions three possibilities:

“One … suggestion is to mint a $1 trillion … coin and deposit it at the Federal Reserve. The Fed would then credit the Treasury’s account, thereby allowing it to go about its business unconstrained by the debt ceiling” (and, we would note, incurring less interest expense).

“A second suggestion … would be for the Treasury to issue ultra-high-interest bonds. Because only the face value of bonds counts toward the debt limit, the Treasury could, in theory, sell … one-year bonds with an interest rate of 105% for twice their face value (since the prevailing market rate is closer to 5%).” That would allow the Treasury to raise twice as much funding as the addition to the national debt.

The third option involves the Treasury borrowing more “in defiance of the debt ceiling … based on a usually ignored provision of the 14th Amendment that American public debt shall not be questioned.”

All three of these possibilities appear to have significant practical and legal difficulties, however.

Park Piedmont acknowledges that the brinksmanship over the debt ceiling might rise to new levels in 2023. We believe that the promise to honor US obligations to taxpayers and bondholders will be upheld, as it has in the past. And even if there is a default, it would likely be remedied quickly once policy makers see the negative results in the economy and financial system.

So we don’t recommend making any short-term portfolio adjustments for clients with long-term investment horizons. For clients with shorter investment timeframes, the wisdom of potential changes would depend on your current exposure to the various parts of the stock and bond markets. In either case, we encourage you to check in with your PPA advisor if you’d like to discuss the implications for your specific situation.