Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. It hasn’t always been as adversarial as this one has become, but now, it seems apparent that an agreement, when it is hopefully agreed upon, will come down to the 11^th hour. Also obvious is the equity and debt markets are unhappy with an agreement being delayed to this extent. Remember, both the Democratic and Republican sides realize that a delay of an agreement before the deadline of approximately June 1^st (as stated by U.S. Treasury Secretary Janet Yellen), would not bode well with financial markets. There is reason to believe an agreement will ultimately be reached soon as it is significantly beneficial to each side to reach one in the very near future.

So, why have the equity markets been holding well over the last few months with all this inflation and recession fear floating around? The reason is economic growth has hung in there. First-quarter growth in gross domestic product (GDP) wasn’t great by any means, but it was positive at 1.1% annualized on an inflation-adjusted (real) basis. Perhaps more importantly, corporate management teams have been preparing for recession for some time, so guidance at the start of the year was perhaps more conservative than it needed to be. China’s reopening provided a small tailwind, while Europe has held up relatively well.

Also, cost controls started to get some attention with the big tech companies in the fourth quarter, particularly for Meta/Facebook (META), but were adopted more broadly during the first quarter, propping up margins which were unexpectedly higher quarter over quarter. The average amount of margin compression in a mild recession has historically been less than 2 percentage points, already experienced by S&P 500 companies.

Lastly, analysts and strategists seem to have forgotten that inflation boosts revenue. Revenue rose 4% in the first quarter of 2023 compared with forecasts below 2% prior to reporting season. Higher prices mean more revenue. Given consumers came into this weak earnings period flush with cash, those prices are being absorbed better than many had anticipated. Nominal GDP, or GDP including inflation, rather than inflation adjusted, or real GDP, rose 7% year over year. Nominal GDP tends to correlate well with revenue over time.

What about interest rates moving forward? Economists like to remind us there is no such thing as a free lunch. In investment parlance, that just means all investments carry risk—even cash. And the big risk with cash is reinvestment risk. That is, while short-term rates are currently elevated, the risk is these rates won’t last and upon maturity, investors will have to reinvest proceeds at lower rates. Yes, the Fed (Federal Reserve) may need to raise rates one- or two more times in the short term, but we could see lower core bond yields over the next year, which would mean cash-only investors may miss out on these higher yields. We certainly are in very interesting times. Feel free to contact Elise or I with any questions and let us know if you have a friend or relative who would like to be on this newsletter list. – Mark and Elise

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