Debt-Ceiling Come-Down: Fiscal Reckoning May Bring Recession, Stock Market Swoon
Worries over the debt ceiling have had the stock market on edge, but an 11th-hour deal to avoid a default may be taking shape. Still, don’t count on a big relief rally because a series of fiscal fights and aggressive Fed tightening appear likely to help push the U.S. economy into recession later this year.
The rocket fuel of easy money and fiscal giveaways that propelled GDP, inflation and, for a long while, the stock market is nearly spent. Now a fiscal reckoning is about to begin. Besides the debt ceiling, Washington must wrestle with the 2024 budget and reckon with the end of the student-loan payment holiday.
The result will be to deepen a spending slowdown at a time that growth already has slowed almost to a stall. Yet the Federal Reserve, after five percentage points of rate hikes, may step even harder on the brakes.
For all these reasons, the U.S. economy likely faces a rough patch in the second half of 2023.
Meanwhile, any debt-ceiling relief for investors will be fleeting because the stock market is about to lose its own fiscal support.
The Treasury’s inability to issue debt in recent months has more than offset Fed efforts to tighten financial conditions by unloading assets purchased during the Covid-19 pandemic. But Treasury issuance is about to surge following a deal to raise the debt ceiling. That means we’re about to get Fed quantitative tightening on steroids.
Talks On The Debt Ceiling, 2024 Federal Budget
The debt-ceiling negotiation faces a possible June 1 deadline. News reports indicated that the emerging deal for a two-year debt-ceiling hike would roll back spending far less than House Republicans proposed. Instead of cutting discretionary spending back to 2022 levels, the cuts would hold nondefense spending at 2023 levels or slightly below, while exempting military and veterans’ health spending.
The White House has been resigned to at least modest discretionary spending cuts as part of a debt-ceiling deal. Even if President Biden attempted an end run — such as by declaring that the debt limit is itself unconstitutional — he’ll still need the GOP-controlled House to sign off on the 2024 budget before the new fiscal year begins Oct. 1.
Failing that, the government could shut down until there’s a spending deal. The last partial shutdown under former President Donald Trump eventually grounded air traffic while delaying paychecks for 800,000 federal workers, as well as contractors. A repeat scenario would surely amplify U.S. recession risks.
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Another time bomb lurks between the debt-ceiling deadline and Sept. 30 — zero hour for a fiscal 2024 federal budget deal. Biden’s $400 billion student-loan forgiveness program faces a Supreme Court ruling in late June. There’s a strong chance Biden won’t like the outcome. Recent rulings by the conservative-dominated court show little patience for government agencies to adopt consequential policies without the explicit consent of Congress.
A ruling against Biden’s program to forgive up to $20,000 in federal college loans per person could hit borrowers by September. Biden has set an Aug. 31 deadline for lifting a three-and-a-half-year moratorium on student-loan payments.
The halt of student loan payments for about 40 million borrowers has cost the government more than $5 billion per month, including forgone interest, according to the Committee for a Responsible Federal Budget.
Yet that understates the extent to which the payment pause for $1.3 trillion in student loans with a median balance of $18,773 has helped consumer finances.
The average student loan payment was $393 per month for borrowers before the pandemic, Jefferies economist Thomas Simons notes. An end to the freeze would equal a 0.6% hit to aggregate personal income, Jefferies estimates.
“Consumer balance sheets are already kind of exhausted at this point,” Simons told IBD.
With the added pressure from an end to the student-loan holiday, “We’re setting up for a pretty significant rollover” for consumer spending in the second half of the year, he said.
Other Fiscal Drags To U.S. Economy
After dodging recession fears in 2022, the U.S. economy appeared to rev back up to start 2023. The Fed responded by turning even more hawkish. Now that burst of growth, which was helped by a mild winter and an 8.7% cost-of-living boost to Social Security benefits, is looking like the last gasp of pandemic-era fiscal fuel.
Two of the last remaining Covid-era supports for household finances have now hit their end date. Emergency SNAP (Supplemental Nutrition Assistance Program) benefits recently expired. That amounted to a hit of $95 per month for eligible households, or nearly $50 billion per year. Medicaid income limits, suspended at the start of the Covid pandemic, are now returning. That could knock up to 17 million people out of the program over the next year, leaving them to find more costly insurance coverage, a Kaiser Family Foundation analysis finds.
Covid-19 Pandemic-Era Giveaways
It’s hard to overstate how pandemic-era fiscal giveaways and ultralow interest rates transformed household finances. Three rounds of stimulus checks, unemployment benefits that were more generous than many paychecks, and expanded child tax credits helped Americans amass $2.3 trillion in excess savings by late summer 2021, a Federal Reserve study found.
An epic mortgage refinance boom cut average monthly payments by $220 for about 9 million families, the New York Fed says. Another 5 million capitalized on lower interest rates and higher home values to take $430 billion worth of cash-out refis.
Another New York Fed study estimates that student loan borrowers saw $195 billion worth of payments waived in the first two years of the moratorium, implying that sum has now grown to around $300 billion.
Fiscal Fuel For Inflation Spike
All of this helps explain why the U.S. economy has held up through 500 basis points of Fed rate hikes — twice the level of tightening that proved untenable in the last cycle. Yet it also explains why the economy has suddenly become much more vulnerable to recession.
That massive boost to savings — even as consumers splurged and paid down debt — mixed with pandemic supply-chain disruptions to set off an inflationary chain reaction. Because consumers had so much spending power, businesses held the pricing power to afford hefty wage hikes and still reap unusually wide profit margins.
Hiring remained strong because wage hikes helped to sustain robust demand. Plus, households gradually began to spend down their extra savings, piling up credit card debt amid high inflation and fast-rising interest rates.
Finally, to start 2023, the biggest inflation outbreak in four decades produced the biggest Social Security cost-of-living increase since 1981. At the same time, employers coughed up one more round of outsized pay hikes as the labor market remained tight.
U.S. Economy Sees Consumers Pull Back
Yet that cycle has now run its course. The consumer already pivoted in the fourth quarter of 2022. The urge to splurge drove the savings rate down to 3% of disposable income by September 2022 from 8%-9% before the pandemic, boosting consumption by about $1 trillion at an annual rate. But caution then started to creep in, raising the savings rate to 4.1% of disposable income by April.
Even so, William Blair economist Richard de Chazal figures that consumers already have spent more than 75% of their excess savings haul during the pandemic.
Retail sales, after a COLA-flavored income bounce to start the year, have trended lower over the past three months, slipping about 1% in April vs. January’s level. Walmart (WMT) and Home Depot (HD), which both announced big minimum-wage hikes early in the year, have seen consumers take a step back. Walmart CFO John Rainey cited the end of emergency SNAP benefits and smaller tax refunds as contributing factors.
Businesses Change Spending Plans
Businesses have pivoted too. Corporations announced 337,000 planned layoffs in the first four months of 2023, according to the Challenger, Gray outplacement firm. That’s up more than 300% from the same period a year earlier. Labor Department data shows that the number of job openings sank by 1.6 million in Q1. That’s the biggest fall in data back to 2001, excluding the April 2020 hit during the Covid-19 pandemic lockdown.
The National Federation of Independent Business’ small business optimism index is at the lowest level in more than a decade. Nearly one-third of small firms say they’re dependent on bank credit at a time when short-maturity loans come with an average 8.5% interest rate, up 5 percentage points from March 2022.
As demand slackens and pricing power ebbs, high borrowing costs likely will push small businesses to cut their biggest expense: labor.
Businesses “are responding to a 500 (basis point) increase in interest rates over the past 14 months, which alone usually would be enough to push the economy into recession, but they now face a credit crunch too,” wrote Ian Shepherdson, chief economist at Pantheon Macroeconomics.
Shepherdson takes issue with Fed hawks eyeing further rate hikes because inflation isn’t coming down fast enough. Not only has the Fed done enough, he says, but a failure to cut rates very soon “will amount to overkill.”
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Can U.S. Economy Avoid A Hard Landing?
A case can still be made that the U.S. economy is headed for a soft landing. While pandemic-era government supports may be on their last legs, infrastructure spending and business investment are enjoying a growth spurt. Three big spending packages approved under President Biden could plow $1 trillion into earthmoving projects over a decade.
Jefferies’ Simons doubts that the ramp in spending on infrastructure, chip plants and green energy projects will come fast enough before consumption fades and layoffs pick up.
Yet others argue that consumer finances look plenty strong to keep the U.S. economy on track.
Despite hand-wringing over a rise in credit card debt, “Households are having no trouble servicing their debt,” wrote Doug Peta, chief U.S. investment strategist at BCA Research.
“We do not see any credit obstacles preventing households from sustaining their consumption growth” by taking on more debt, Peta said.
Yet the end of the student-loan moratorium could be a game-changer for consumers, while deepening problems for banks. Even without student-loan obligations, credit card and auto-loan delinquency rates have climbed back to pre-pandemic levels, New York Fed data shows.
Delinquencies are highest for younger borrowers, who are more likely to hold student loans in forbearance. Once those payments resume, delinquencies may spike.
The unknown fate of student-loan relief complicates the outlook for the U.S. economy and the stock market.
Even if the Supreme Court strikes down student-loan forgiveness, the White House has a backup plan. The Congressional Budget Office estimated that Biden’s Plan B, limiting repayment based on income, would cost the government $230 billion. While that might minimize the economic hit once the moratorium ends, this relief plan also could get tangled in a legal fight.
That raises a big question: Will Biden let the moratorium end on schedule, risking a backlash among younger voters who have been his biggest supporters?
Stock Market Rally Faces ‘Liquidity Storm’
Hopes for a debt-ceiling deal helped lift the S&P 500 last week to its highest close since August. The evaporation of those gains is not too worrisome as the deadline nears without a deal in sight.
Yet investors should be on guard for a bigger stock market pullback, if history is a guide. The S&P 500 rallied a few weeks ahead of the 2011 debt-limit deadline. But the stock market turned down ahead of the deal, and the sell-off continued as the ink dried. The S&P 500 dived more than 10% in two weeks surrounding the Aug. 2 debt ceiling deal.
A replay of that stock market sell-off is far from certain, though it may take some financial market stress to convince debt-ceiling negotiators to compromise.
Still, investors have reason to worry that the immediate aftermath of a debt-ceiling deal might not be pretty, as the dam on Treasury issuance bursts.
For regional banks competing with high bond yields as they try to minimize deposit flight, the coming increase in Treasury issuance “is likely to make things worse,” Simons wrote. That risks a further tightening of lending standards.
Barry Knapp of Ironsides Macroeconomics told clients in an audio note that he sees the S&P 500 falling as low as 3,850 as the reprieve from Fed quantitative tightening abruptly ends.
“We’re on the verge of what we would describe as a liquidity storm,” he said.
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