The Elephant in the Room

The current debt ceiling debate in Congress is a great reminder that investors should always prepare for the unexpected and invest in companies that are durable enough to withstand a range of economic scenarios.

It has been our experience that markets are more volatile when outcomes do not meet investors’ expectations. For example, if investors are expecting the Federal Reserve (Fed) to raise rates by 75 basis points, those who expected the decision would not necessarily see a reason to move the markets, while those that are surprised would likely think the markets were mispriced given the new information. This is a variation of the efficient market hypothesis, but one in which expectations, rather than information, drive what is and is not priced into the markets.

Such moves are most dramatic when the unexpected is not just an unanticipated outcome of a known event but an unforeseen event entirely. Take the Covid-19 pandemic, as well as the global reaction to it. The magnitude of the market reaction was, in our opinion, a direct result of the magnitude of surprise felt by both Wall Street and Main Street, in this case made more extreme when paired with the equally powerful emotion of fear.

As investors and risk managers, we believe a prudent investment process aims not only to identify and quantify the market’s largest known risks but also to think about risks that are less obvious in order to mitigate the impact of both expected and unexpected events. To that end, we think it is worth highlighting the U.S. Congress, which we believe has the potential to impact the economy and the markets to an extent greater than the Fed’s interest rate policy over the next two meetings.

The Fed has not yet had the full impact on inflation and the economy that it has been hoping for. Though it has correctly cited a lag effect to explain when policy changes will manifest themselves in the economy, patience is in short supply among many market participants today. But Congress may be giving Fed Chairman Jay Powell and the U.S. economy an unwelcome push. In December, while the markets were focused on what was ultimately a predictable decision by the Fed to raise interest rates by 0.5%, our focus was on the frantic negotiations taking place in Congress to pass a budget bill by December 23.¹ To be clear, there was little risk of a failure to strike a deal and avoid a government shutdown. So why did this capture our attention?

Our concern stemmed from the risk of what happened two weeks later: the now well-known difficulty Congress had in electing a new Speaker of the House of Representatives. The successful election of Kevin McCarthy to the position took 15 rounds of voting over several days, the most ballots needed for Congress to elect a leader since 1859.² Though the inevitability of a leader has become almost a given, there were a few representatives this year who felt compromise was failure. Among the demands they made, and to which Kevin McCarthy eventually acquiesced, was that any one member of Congress be allowed to make a “motion to vacate.” Such a motion would force a vote to remove the sitting Speaker and would take precedence over any other business then before the House.

On the surface, this seems to be a significant change. Bringing a motion to vacate previously required a majority of a party caucus. Reducing this threshold to a single member makes more chaos feel like an inevitability. However, it must be noted that, until 2019, the House rule was already set at just one member. We would like to take comfort in the fact that such a low bar to attempt to oust previous Speakers was not abused,³ but we cannot dismiss the risk that this time may be different. If the unprecedented Speaker election is any indication, a motion to vacate, once largely a theoretical possibility, may become a realistic probability with serious consequences.

Kevin McCarthy now finds himself backed into a corner. To avoid being removed from the Speaker’s chair, legislation he brings to the floor would likely need to be acceptable to the handful of far-right House members who pushed him into that corner. To become law, that same legislation would need to be acceptable to Democrats, who hold a majority in the Senate. As the country heads into a presidential election in two years, this is a recipe for a Congressional session during which only uncontroversial bipartisan bills are likely to reach President Biden’s desk. It is difficult to see how a hawkish budget that would appeal to these same Republican House members would pass in the Senate.⁴

Legislative inaction in general is not necessarily a big market risk per se, but the failure to pass a budget and a subsequent government shutdown would be. Though failure was not a big risk in December, kicking the can down the road was. If the solution had been a stopgap resolution to fund the government for just a few months, the budget debate would have been pushed to the first quarter of 2023, right after a predictably contentious start to the Congressional session and in the middle of the Fed’s balancing act. A looming government shutdown may not have just given the economy a gentle push downhill but possibly shoved it off a cliff.

Fortunately, a deal was struck in December to fund the government for a full year. That gives the Fed’s policies time to take hold and gives this Congress time to get past the initial disorder. But if the House cannot find its footing and pass a budget in that time, we may be facing a different budget scenario, with the prospect of hundreds of thousands of people being furloughed by the largest employer in the U.S. right before the holidays in 2023. We believe the same members of Congress who were willing to disregard precedent and optics in January are less likely to be deterred by the consequences of a prolonged and painful shutdown, last experienced in late 2018, still recent enough for many to remember.

But why are we bringing this up now? In today’s market, December is a lifetime away. The reason is because the budget passed in 2022 faces a more imminent obstacle: How will it be funded? Many readers will by now be familiar with the need for Congress to increase the U.S. debt ceiling. Treasury Secretary Janet Yellen pointed out that the current limit was reached on January 19, 2023. While “extraordinary measures” will be taken to prevent an immediate default, it is likely that the government only has the flexibility to buy itself time until the summer of 2023. This sets up a near-term deadline for Congress to avoid defaulting on U.S. government debt.⁵

To be clear, we believe this risk could be lower than feared because it is less likely that Democrats would object to joining Republicans in a bipartisan effort, as long as the debt ceiling increase is passed in a clean form (i.e., without agenda-driven amendments). The flaw in this logic lies in another concession made by Kevin McCarthy on his path to the Speakership. He agreed that any increase in the debt ceiling would be accompanied by corresponding budget cuts. In doing so, he accelerated a version of the budget standoff, with all of the same complex and difficult dynamics, to this summer.

This may not yet be the most probable outcome, but these are scenarios to which we believe investors should be paying close attention. A debt default is a real possibility. Lenders to the U.S. government would need to factor in potential downgrades and credit risk into the yields they demand to buy U.S. Treasuries. Longer term rates could increase, and the U.S. dollar may weaken, which would put pressure on valuations but could also give a lift to some bond issuers whose credit risk might look relatively more attractive. And the recession people are fearing, but may not get from Fed action, might very well happen because of Congress.

The silver lining here is that, for better or worse, the potential for brinkmanship (or crisis) that we are seeing in Congress may still be unexpected, but it is (un)fortunately no longer unforeseen.⁶ This brings us back to our philosophy of preparing for the unexpected and seeking resilient investments help to defend against unanticipated events. In our view, prudent investors are best served by focusing on company fundamentals and considering potential scenarios not because they are likely but because they are not improbable. We believe the end results are portfolios in which those seeking capital preservation can have greater confidence across a variety of both mainstream and contrarian outcomes.

1 To be fair, the Fed decision, as telegraphed as it was, did surprise some market participants and resulted in a meaningful move in prices. Here, once again, we find a paradox of unexpected expectations. For an investor to position a portfolio to profit from a market move driven by a high probability outcome seems to be a poor allocation of mindshare.

2 The disagreements at the time were so profound that it took nearly two months and 44 ballots to choose a Speaker, just four years after a vote that took 133 ballots. Less than two years later, those divisions caused Southern states to secede from the Union, leading to the U.S. Civil War.

3 There have only been two motions to vacate in the history of the House of Representatives. The first was in 1910, and the vote failed. The second was in 2015. Notably, the latter motion to oust then-Speaker John Boehner was made by a member of the House Freedom Caucus. Some of the recent members of this same caucus were responsible for much of the commotion and delay during this year’s Speaker election. Fortunately, the 2015 motion was never intended to receive a vote, but rather was a way to force a discussion about House rules. To that end, the member made the motion non-privileged, meaning it went through committee before coming to a vote like any other legislation, and was never brought to the floor. Even so, this less-consequential show of no confidence led to Boehner stepping down as Speaker of the House when he determined he had lost the ability to lead.

4 The two most likely ways in which a budget could get passed, either a bipartisan deal from the start or a deal in the Reconciliation process between the House and Senate Budget Committees, which garners majority support in both chambers, are very narrow paths. We are watching committee assignments with interest to see who will be negotiating the compromise, and there are some positive signs that an impasse can be avoided. But we are already deep in the nuance here, which does not bode well for a market that prefers headlines to details.

5 There is some debate as to whether this has ever happened in the history of the United States. There are several examples, none since 1971, to argue yes, but in all but one case, the ability of the government to repay debt was not in question as much as the government chose to not honor specific obligations. That one case was in 1862, due to the financial strain of the Civil War. In that sense, if the U.S. defaults this summer, this would be a first in modern U.S. history, though just the threat of a default in 2011 led to a first-ever credit rating downgrade below AAA by Standard and Poor’s of the U.S. federal government. And, by the way, is anyone else concerned that today’s government standoffs keep eliciting comparisons to the Civil War?

6 The Great Recession also surprised many investors, but some were able to identify the risk in the markets even if the timing was harder to pinpoint. That episode is a good example of how extreme a move in the markets can be if most investors are not expecting an outcome despite warnings from those who saw it coming.

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Originally Posted January 27, 2023 – The Elephant in the Room

This commentary contains the current opinions of the authors as of the date above and is subject to change at any time. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.

Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.

A basis point is a unit that is equal to 1/100th of 1%.

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