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Market turbulence ahead as US debt debacle deepens

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By Charbel Kadib
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4 minute read

Investors could capitalise on a looming “pullback” in the equities market, with the ongoing US debt ceiling dispute to go “down to the wire”, UBS has projected following a US government ratings downgrade.

The United States’ “AAA” Long-Term Foreign-Currency Issuer Default Rating (IDR) has been placed on “Rating Watch Negative” by Fitch Solutions off the back of continued uncertainty surrounding negotiations to raise the government’s US$31.4 trillion (AU$48 trillion) debt ceiling.

In a statement released on Wednesday (24 May), Fitch Solutions said the revision reflects “increased political partisanship”, with the White House unwilling to cede to the Republican Party’s demands for more spending cuts.

The ratings agency still expects a resolution ahead of the 1 June deadline but stressed “risks have risen”, claiming the government “could begin to miss payments on some of its obligations”.

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Fitch continued: “The brinkmanship over the debt ceiling, failure of the US authorities to meaningfully tackle medium-term fiscal challenges that will lead to rising budget deficits, and a growing debt burden signal downside risks to US creditworthiness.”

The US surpassed its debt limit on 19 January 2023, just over a year after it was raised by approximately US$2.5 trillion (AU$3.8 trillion).

As at 23 May, the US Treasury’s cash balance totalled just US$76.5 billion (AU$117.2 billion), casting doubt over whether the government can repay debt due on 1 June.

According to UBS Asset Management, negotiations to raise the debt ceiling would likely go “down to the wire”.

UBS said a US government debt default is “very unlikely” but warned it would pose “significant” risks to the financial system.

“The most severe financial distress occurs not when assets that are known to be risky suffer, but rather when assets that are widely believed to be safe fail,” the asset manager observed.

“It is very likely that the negative ramifications are not possible to fully identify ex ante, but may include ratings downgrades of the United States, forced selling of US Treasuries, faults in funding markets and broader systemic stress.”

In the meantime, the protracted saga is expected to rattle markets.

“The risk of a default on US Treasury obligations is extremely low. A compromise agreement by early June is more likely than not,” UBS noted in a statement released on Thursday (25 May).

“But volatility is poised to increase in the near term, as markets are likely to price in some risk of a disruptive outcome between now and then.”

But according to UBS, investors may have an opportunity to capitalise on equity market pullbacks triggered by debt ceiling uncertainty.

“We believe the macroeconomic landscape will become more supportive of risk once this large potential headwind is behind us and believe a deal will be struck by early June,” the asset manager noted.

“Any meaningful pullbacks in the stock market linked to concerns about whether a debt ceiling agreement will be reached or if the US government will not service its debt obligations may be an attractive point to increase equity exposure, in our view.”

A rally would be underpinned by corporate resilience to weakening economic activity.

“Corporations have retained pricing power amid a slowing in economic growth — and nominal activity is still high and has room to decelerate further without triggering recession fears,” UBS added.

“The aggregate amount that US companies exceeded expectations increased for both the top and bottom lines during the most recent reporting period.

“The resilience of nominal activity and margins suggest that downside to earnings is limited outside of recession, which we do not believe is imminent.”

When assessing the broader macroeconomic environment, UBS said it expects inflationary pressures to continue abating, paving the way for a prolonged pause to monetary policy tightening regimes.

“Ahead of debt ceiling talks, our relative value positioning in equities and foreign exchange became somewhat more defensive, in line with our belief that there will be some unease in markets along the way to an eventual deal,” UBS stated.

“We are prepared to be nimble to take advantage of opportunities that arise across asset classes if debt ceiling headlines drive market dislocations in the days to come.”

In Australia, the ASX 200 and All Ordinaries Index have lost 2 per cent of its value since debt ceiling negotiations broke down last Friday (19 May).

This mirrored a 2 per cent fall to the Dow Jones Industrial Average over the same period, while depreciation in the Nasdaq Composite Index has been less pronounced (1.3 per cent).

Market turbulence ahead as US debt debacle deepens

Investors could capitalise on a looming “pullback” in the equities market, with the ongoing US debt ceiling dispute to go “down to the wire”, UBS has projected following a US government ratings downgrade.

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