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May 15, 2023 - Will the US default in June ?



The answer is : ... most probably not. However, the situation is not something that we should take it lightly. As the amount of government debt in the US is constitutionally limited, there is almost every year the need for the passage of law to bypass this obstacle, in order for the government to be able to borrow and function (and of course pay maturing bonds). The problem is that this year the House belongs to the Republicans and the Senate to the Democrats, hence the passage of the law would require tough negotiations and compromises between the two parties. Democrats wish to pass the extension of the debt ceilint without any conditions, Republicans want the agreement of the Democrats on significant government spending cuts. The first meeting last week did not produce any results, while a planned meeting on Friday was postponed for this week. Donald Trump, who is running again to become the Republican nominee for President, said that a default should be an option, in order to push democrats to sign the cuts in spending. This could get ugly before the situation is finally resolved.


The Treasury Secretary, Mrs. Yellen, has already warned that sometime in June the government will not have enough cash to make payments for maturing bonds and a default could happen. To put this situation in historic context, it resembles the summer of 2011, when again we had a split Congress under President Obama's second term. And although the US government finally did not default and a last-minute agreement was made, the S&P500 dropped by more than 15% in a matter of just two weeks.


The April US inflation data gave us reason to smile. The headline number fell below 5% to 4.9% on an annual basis and it is on track to meet our (last year) expectations for inflation closer to 4% in the summer of 2023. Core CPI increased by 0.4% on a monthly basis, little higher than expected (0.35%) and the annual rate fell to 5.5%. It should be noted that one-third of that increase came from used car prices, which spiked in April and which account for only about 3% of core CPI expenditures. Outside of used cars the core CPI rose 27bp, which is the smallest increase since August 2021. The best news came from owners' equivalent rent and tenants' rent, which combined account for 40% of the core CPI with another increase that was well below the pace observed every month in the 10 months from May through February.


The Bank of England raised rates by 25bp to 4.5%, in line with consensus. As expected and similar to the last three meetings, there was a split of opinions, with 7 members voting for a 25bp hike and 2 members voting for a pause. While the Committee left its forward guidance unchanged ("If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required"), its tone was somewhat more hawkish than in the March meeting, according to many analysts. This leaves the door open for another 25bp hike in June, much like with what the ECB is expected to do.


More confirmation on the US labor market's deterioration was received last week. The weekly initial jobless claims jumped to 264k, which is the highest number since the last quarter of 2021. It is also higher than the pre-pandemic average of the 2018 and 2019 years. In absolute terms, the number is still not worrying as it would take a move above 300k to make the case for a recession an almost done deal. However, the direction of travel of the unemployment benefits has been clearly north in the last 6 months, and more pain is to be expected. Nevertheless it is the intention of the FED to "hurt" the jobs market and raise unemployment in order to make sure that inflation comes down and stays down.


The China trade data for April were rather weak. Imports fell by a whopping 8%, which shows a remarkable slowdown of local consumer demand. As the wave of spending post-pandemic is starting to wane already, we must monitor very closely the rest of the data which show that global demand and hence the global economy is undergoing a major slowdown. The Dry Bulk Index, for example, which is a measure of the demand for international shipping transportation is down 12% this year and has fallen 80% from the 2021 peak. Iron Ore prices, which are a gauge for demand of new buildings and construction, has fallen 6% this year, having fallen 15% in just the last month.


Equities were slightly negative for the week, with some pockets of green for Nasdaq and Swiss stocks. As the S&P500 has approached again strong resistance levels (4150-4200), it struggled to move higher, despite the ongoing interest inTechnology names, boosted by the artifficial intelligence hype. Europe was mostly down but only slightly, with France and Germany falling between 0.1% and 0.3%. Chinese stocks continued to be weak, with the CSI300 falling 2%. In terms of sectors, Communication Services had a positive week, helped by Alphabet (Google) which announced changes to its search engine , now powered by AI.


Bonds had a volatile week, but finished slightly higher. The US 2-year yield fell to a low of 3.85% but recovered towards 4% again on Friday. We should note however that short positions in Treasury futures, ie positions which bet that bond prices will fall and yields will move higher, have reached record levels, since the CFTC started taking measurements 30 years ago. The net short in the US 2-year Treasury is now 50% greater than what it was when the Fed was working through the 2017/18 hiking cycle. It’s the same story in the 10 -year and just in 2023 so far, the net short has tripled in size. If the US economy does drop into a recession, the short-covering (ie buying bonds to cover the shorts) will drive bond prices even higher. We remain overweight in high quality bonds.


Corporate results : The Q1 2023 results are almost over, with 85% of the S&P 500 companies having reporting. Out of these, 79% has reported a positive profits surprise and 75% have reported a positive revenue surprise. We shoud note, however, that earnings expectations for this quarter had been reduced significantly ahead of the results, so the correct characterization is that overall results were better than feared. The earnings decline for the S&P 500 is -2.2%, until now, compared to the same quarter of last year, with the fears being that they would fall more than 6%.



Chart of the Week : The US has a higher probability of default than Greece, now.



The above chart shows the cost for insuring against a default in the bonds of the US government (the blue line) and the Greek government shown in green, or in other words the CDS, as it is called. The higher the CDS is, the higher the probability of a default becomes, so the "premium" to be paid is higher for the investors who buy them. We can see that the US CDS has skyrocketed in the last month to over 160bp, while that of Greece's has stayed relatively calm at around 40bp. We belong to the camp that does not believe that a default will actually happen, so this is more of a temporary anomaly in the market, but we thought it would be a fantastic picture to show and keep in our archives. More than 10 years since Greece defaulted, its CDS trades much lower than the US , even if that will only last for a few more days.


Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.

• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.

• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.

• Sources: Chart of the Week : Factset

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