The Pinnacle: May 2023

June 19, 2023 TallRock Capital

MAY 2 0 2 3 • I S S U E 30

May Markets

May was a month in which markets were mostly driven by a few major headlines. One such headline was the debt ceiling negotiations where an agreement was finally reached days before the deadline. Other topics driving the markets included the path forward for central banks and continued concerns over stability in the banking sector. Notably, oil was down 40% year-on-year (YoY) during May, largely due to a high base from a year ago when the Russia-Ukraine war caused a large spike in the price of the commodity.

In the US, April’s YoY inflation number came in at 4.9%, which was down from 5% where it was expected to remain. This minimal decline in YoY inflation heightened the fear that inflation may start becoming ‘sticky’ at this point and has made some question whether the US Federal Reserve (Fed) will pause with rate hikes as originally expected.

As mentioned, debt ceiling negotiations between Democrats and Republicans dominated news headlines for May. A deal to suspend the debt ceiling has now been agreed and signed by US President, Joe Biden, after having been approved by The House of Representatives and The Senate. Despite the tense negotiations, US equities remained resilient, with the market always expecting an agreement would be reached and remaining reasonably stable.

In the UK, the Bank of England (BoE) raised rates by 25 basis points to 4.5% in June. Inflation fell significantly during April, as the YoY number came in at 8.7%, down from 10.1% previously but higher than the 8.2% expected. The lower-than-expected fall in inflation contributed to continued macroeconomic worries in the region, as the UK continues to lag behind its developed market peers in fighting inflation. It is expected that rates will peak at 5.25% to 5.50%, with the possibility to see a rate cut in the first quarter of 2024. UK equities responded negatively to the inflation numbers as well as low commodity prices.

In the Eurozone, the European Central Bank (ECB) raised rates by 25 basis points taking the deposit rate to 3.25%. Two further 25 basis point interest rate hikes are expected meaning that the deposit rate would be expected to peak at 3.75%. Inflation came in at 7% YoY for April, 0.1% higher than a month previously. Food inflation continues to put pressure on consumers despite a 1.9% YoY decline to 13.5%. The ECB faces a similar challenge to the Fed as inflation is seemingly proving ‘sticky’ at current levels. Equities proved to be not as resilient as in the US, with Europe Ex-UK equities falling in May.

China finds itself in a different position than the other major economies discussed. While the other economies grapple with bringing inflation down, China, on the other hand, is struggling with inflation that is persistently too low, bordering on deflation. China’s CPI currently stands at 0.1% YoY.

Source: Investec

Despite having achieved an impressive 4.5% GDP YoY growth in the first quarter, this was largely spurred on by China’s return to economic activity after ending its Zero-Covid Policy. In the second quarter, this momentum has somewhat fizzled out with the Chinese government considering increasing stimulus as a method to assist with re-accelerating growth.

Singapore’s economy surprised estimates by growing at 0.4% in the first quarter of 2023. Despite this, the country’s Ministry of Trade and Industry (MTI) warned of increasing “downside risks” with factors such as rising interest rates and the Russia-Ukraine war at play.

With the risk of the US government defaulting on its debt being avoided for the time being, other key factors should be monitored in the months to come. Some of these are how far central banks will go in raising rates, and whether the banking sector has shaken off its troubles experienced earlier in the year.

US Debt

The US recently faced the risk of breaching its debt ceiling that has continued to increase over the decades. With barely two days to spare, President Joe Biden on Saturday signed a law (Fiscal Responsibility Act of 2023) suspending the $31.4 trillion debt ceiling of the United States government, preventing what could have been a first-ever default.

The U.S. debt ceiling is a limit Congress has placed on how much money the federal government may borrow. It acts as a ceiling on the total amount of debt that the Treasury may issue to finance governmental functions. Congress must enact legislation to increase or suspend the ceiling when the debt hits it, allowing the Treasury to borrow more. Failure to increase the debt ceiling might result in a potential default, which would have serious economic repercussions.

As of the first quarter of 2023, the US government debt level is $31.4 trillion. Since the early 1980s, the national debt has increased dramatically under Republican and Democratic governments. Presidents George W. Bush and Ronald Reagan both implemented tax cuts that resulted in significant deficits, which caused the debt to grow at the highest percentage rates throughout their administrations. The wars in Iraq and Afghanistan, the 2008 financial crisis, and the 2020 COVID-19 pandemic are just a few of the events that have significantly added to the debt during the past 50 years. The latter two prompted Congress to enact broad stimulus measures that cost trillions of dollars.

The Conference Board outlined that the newly passed law pushes back the next debt ceiling discussion bill until after the elections in 2024. However, it suspends the debt cap rather than increasing it. For the fiscal years 2024 and 2025, overall spending will increase slightly, about in line with anticipated inflation. While domestic discretionary expenditure will decrease by $1 billion for 2024, defence spending and veteran spending are both protected (and will climb).

Some of the major items in a bill resulting from negotiations between the White House and Congress are:

No changes to entitlement programs: The bill does not modify funding for Social Security, Medicare, or Medicaid (considered domestic discretionary spending).
Work requirements for SNAP recipients: The bill includes work requirements, potentially up to 20 hours per week, for able-bodied recipients of the Supplemental Nutrition Assistance Program (SNAP) until 2030. However, categorical exemptions are provided for certain recipients, such as the homeless and veterans.
IRS funding: The Inflation Reduction Act approved $80 billion over ten years for IRS modernisation, but the FRA removes $20 billion of that funding, which reportedly applies to the final two years. The reduction does not significantly impact IRS modernisation efforts for the immediate future.
No tax increases: The bill does not include provisions for new revenues.
Recissions: Unspent funds from COVID relief measures, estimated to be around $27 billion, will be returned to the Treasury instead of being spent.
Permitting reform: The bill amends the National Environmental Policy Act to assign a lead federal agency responsible for environmental impact assessments or statements, but it does not limit judicial review or impose barriers to challenging permitting decisions in court.
Mountain Valley Pipeline: The bill orders the federal government to grant the necessary permits for the Mountain Valley Pipeline, which will carry 2 billion cubic feet per day of methane gas 300 miles from West Virginia across several miles of National Forest.
Student loan payments: The bill codifies the end of the pandemic-era pause on student loan repayments, removing the President's discretion to extend it. However, it does not address the Administration's proposed student loan forgiveness plan.

Markets were relatively quiet, showing confidence that a substantial risk of a debt default was not present. Additionally, the Dow increased by 700 points on Friday June the 2nd after the Senate decision.

While markets may have viewed the suspension of the debt ceiling in a positive light, Fitch Ratings maintains the Rating Watch Negative (RWN) on the U.S. rating despite the fact that the debt limit impasse has been resolved and the government is now able to pay its obligations. This is because the ratings agency is still evaluating the full effects of the most recent episode of brinksmanship as well as the outlook for medium-term fiscal and debt trajectories. Fitch argues that frequent political stalemates over the debt ceiling and last-minute suspensions prior to the x-date (when the Treasury's cash reserves and extraordinary measures are depleted) undermine public trust in the administration's ability to manage fiscal and debt issues.

On the upside, Fitch feels that the scale of the economy, the high GDP per capita, and the robust business climate are among the unique features that underpin the US rating. Because the dollar is the most prominent reserve currency in the world, the government has unmatched funding flexibility. However, over time, poor governance could lose some of these advantages.

In 3Q23, Fitch expects to dissolve the Negative Watch on the United States' "AAA" rating. Their evaluation will be heavily influenced by the coherence and credibility of policymaking, as well as the anticipated medium-term fiscal and debt trajectories.

Emerging Market Interest Rates

While central banks in developed nations have embarked on rate hiking cycles over the last 18 months, emerging nations have implemented similar rate increases of their own. Making up a significant proportion of the global economy, it is important to look at where key regions currently stand in terms of their rate-hiking cycles. It is also important to look at how interest rate changes in developed economies have knock-on effects on emerging markets.

China sits in a different position from other major global regions when it comes to rate hikes and inflation. On Thursday the 8th of June, China’s six state-owned commercial banks cut interest rates for savers. This is a sign that there will likely be further rate cuts. These cuts are expected to pave the way for the Chinese Central Bank, the People’s Bank of China (PBOC), which has lowered it's 7-day reverse repo to 1.9% vs 2.0% previously while similar cuts are expected for the medium-lending facility (MLF) and loan prime rate (LPR).

China faces the dilemma of slowing growth and too-low inflation. China did however produce impressive growth of 4.5% year-on-year (YoY) in the first quarter of 2023. While this growth was triggered by China’s emergence out of strict Covid lockdowns, this momentum has largely faded. Continued uncertainty in the economy due to geopolitical tensions, amongst other factors, has caused households to choose to save rather than spend. Whether China’s likely path of rate cuts will work in accelerating inflation and economic growth will be seen in the coming months.

Most other emerging markets have followed a similar path to developed nations with their rate changes in recent times. South Africa has raised its main policy rate by 450 basis points since the start of 2022 to fight high levels of inflation. While fellow BRICS nations, India and Brazil, have raised rates by 250 and 450 basis points respectively over the same period.

Recently rate hikes have slowed or been brought to a halt in these regions. Most developing nations have experienced weak growth in recent times and are seen as the most eager to begin the process of cutting rates. Hungary was amongst the first to reduce rates with a 1% drop in May, despite annual inflation being at 24% in April. Analysts have warned that emerging markets may feel more pain down the line if they choose to cut rates too early.

Between the beginning of 2021 and its high in September 2022, the US Dollar index increased by 28% against a basket of other currencies. US Dollar’s appreciation had been supported by the Federal Reserve's (Fed) decision to increase interest rates to combat its local inflation, which resulted in higher, more attractive, US Treasury yields. Some overseas markets underperformed in terms of the US Dollar due to the strong appreciation, especially those where the local currencies have significant inverse relationships with the US Dollar, such as emerging markets. Recently there have been expectation that the Fed may be nearing end of their tightening cycle. As a result, the US Dollar has been declining for the last several months which has been supportive for emerging markets.

The actions of central banks in emerging economies will have a significant impact on the global economy going forward. How much pain central banks are willing to let their economies endure before beginning to cut rates will be key to watch. External factors such as the impact of the US Dollar will certainly affect the thinking of emerging market central banks.