May 24, 2023
Yesterday’s risk-off trade occurred 10 days before the estimated debt ceiling x-date of June 1. The timing of the sell-off matches the timing from the 2011 episode that came down to the wire, but still resulted in a US sovereign credit rating downgrade. The credit rating downgrade from 2011 generated a single day decline of ~5% and a peak-to-trough decline of ~20%. This time is different, but not better. A credit rating downgrade now might create greater downside than it did in 2011 when monetary policy was easing, money supply was expanding, inflation was low and valuations were reasonable. Ultimately, an agreement to reduce fiscal spending would be positive for equity markets given still-elevated rates of inflation.
Today’s US dollar strength may also reflect growing concern for a possible US credit rating downgrade. It seems paradoxical, but the last two US sovereign credit ratings downgrades resulted in a flight to quality trade that strengthened the dollar. Dollar strength also follows China’s first growth downgrade since its reopening. This removes a key counterweight for the dollar and the associated softening in the global demand means relative dollar strength could last a while.
Yesterday we cited a handful of technical and macro fundamental headwinds for the S&P 500 (SPX) as the index probes the upper-end of resistance in the mid-4100s. Our calendar year 2023 outlook used ~4200 as a level that would likely cap all rallies during the first half of the year. A sustained break above 4200 would be surprising, but it wouldn’t change our outlook unless it was achieved with deep cyclical leadership. In our view, sustaining levels above 4200 requires a change in macro fundamentals, specifically a Fed pivot. Market-based expectations for year-end rate cuts have bearishly repriced, but the SPX has remained relatively resilient. That needs to be resolved. Setting the debt ceiling debate aside, we expect equities will ultimately follow macro data. We’ve identified weekly jobless claims as the key macro data point to watch with sustained levels above +260,000 driving a retest of the October low near 3550. We look forward to a cyclical recovery driven by easy monetary policy and expanding money supply after a period of economic pain.