VTI - Is The Debt Ceiling Going To Cause A Selloff Similar To 2011?

2023-05-18 10:15:08 ET

Summary

• Stocks dropped almost 20% in the 2011 debt ceiling window.
• Treasury market performance highlights a significant difference between 2011 and 2023.
• 2023 credit markets are telling us to monitor the S&P 500's still constructive trend with a more skeptical eye.

2011 Case Was Painful

Given Janet Yellen has stated the U.S. government may have trouble meeting its obligations as soon as June 1, it is a good time to keep a close eye on the market's tolerance for risk. The poster child for poor debt ceiling outcomes is 2011 when the S&P 500 ( SPY ) dropped 19.82% from the May intraday peak to the October closing low.

European Debt & Regional Banks

The European Debt Crisis was another major factor contributing to the 2011 selloff in global stocks. While Europe is relatively stable in 2023, the present-day markets are dealing with financing and confidence issues in the U.S. banking system. Ultimately, market selloffs are based on a tipping point between the acceptance of risk and risk aversion. Thus, with the 2023 debt ceiling X-date fast approaching, it is prudent to compare the market's profile in 2011 to the 2023 profile.

2011 Was A Different Animal

The performance of long-dated U.S. Treasury bonds ( TLT ) in 2011 (top chart below) relative to their performance in 2022-2023 highlights a significant difference between the two periods. The demand for safe-haven Treasuries was increasing for five months prior to the July 31, 2011 debt ceiling agreement. In 2023, demand for TLT has been tepid, especially over the past six weeks, possibly reflecting concerns about the long-term imbalance between projected tax revenues and future entitlement spending.

S&P 500's Trend

In 2011, party leaders came to a debt ceiling agreement on Sunday, July 31. Rather than rally, stocks sold off hard in early August 2011 (chart below). In addition to the problems in Europe, liquidity concerns related to the Treasury General Account (TGA) and the ability for the U.S. government to issue additional debt most likely contributed to the rapid decline in stocks following the July 31, 2011 debt ceiling agreement. Liquidity factors need to be considered in 2023 since the government will eventually need to replenish the TGA, which removes liquidity from the system.

Notice in the 2011 chart above, the S&P 500's intermediate-term trend was weakening for approximately two months before the July 31 debt ceiling agreement (see slope of 50-day moving average in blue). After the July 31 agreement, the S&P 500's long-term trend deteriorated (price drops below a flattish 200-day moving average in red).

In contrast to the weakening trend look in 2011, the S&P 500's intermediate and long-term trends have been improving since the October 2022 low (see green highlights in the chart below). The percentage of stocks showing strength (market breadth) has been deteriorating since the February 3, 2023 much stronger than expected monthly labor report. The S&P 500's trend is holding up well thus far but has become more vulnerable in recent weeks. If the 2023 chart below begins to morph into a look similar to the 2011 chart above, concerns would increase.

Credit Markets 2011 vs. 2023

There are numerous ways to examine the credit markets, including comparing a diversified basket of higher-yielding bonds ( AGG ) with higher credit risk to lower-yielding Treasuries ( IEI ) with lower credit risk. In 2011, the AGG vs. IEI ratio peaked well before the July 31, 2011 debt ceiling agreement.

The same AGG vs. IEI ratio had a constructive base-building look until late April 2023 (see chart below). In the last two weeks, the chart has started to break down, reflecting concerns about numerous topics, including the debt ceiling, earnings, and default probabilities.

This video expands on the pros and cons as they relate to the market's tolerance for risk as the debt ceiling negotiations look for middle ground.

Political Climate

Market participants may be in for a volatile ride in the coming weeks. In the long run, the most likely outcome is a resolution to the current debt ceiling impasse. However, given the "win the next election" mentality and an increasingly hostile environment in Washington, it is possible the gamesmanship will be taken a bit further than in past debt ceiling episodes. Thus far, the equity markets have held up well, but the credit markets are telling us to pay closer attention while respecting a broad range of outcomes.

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