The United States government is inching closer to its so-called debt ceiling X-date, when the Treasury could run out of cash and extraordinary measures to pay all government obligations, and both political parties remain at odds with no concrete solution to avoid a default.
And while the odds of the US government defaulting on its debt still remain relatively low — it would likely trigger an economic disaster and both sides of the political aisle have a lot to lose — Wall Street is wary of what the ongoing debate means for equity markets.
Defaulting on the US debt would be "potentially catastrophic," JPMorgan CEO Jamie Dimon said last week. "The closer you get to it, you will have panic. Markets will get volatile, maybe the stock market will go down, the Treasury markets will have their own problems," he said. "This is not good."
Investors don't appear to be panicking just yet; stocks rose modestly on Monday. But this fear of market volatility isn't going away.
A similar fight around the debt ceiling in 2011 spurred a serious bout of market volatility. Wall Street's key measure of volatility, the VIX, reached two-year highs and soared more than 35% in just one day.
Between July and August of 2011, the S&P 500 fell about 17% — but interest rates were close to zero at the time, and the Federal Reserve was expanding its balance sheet. All of that provided a cushion for the US economy, said BlackRock analysts in a note on Monday.
With elevated inflation, interest rates at 5% and credit tightening, "the backdrop is very different today," they wrote.
"Brace for higher volatility because of the combined effect of debt ceiling concerns and financial cracks from rate hikes," they said. Even if a deal is struck before the US Treasury runs out of money, they added, "we expect the debt showdown to stoke market volatility."
Wells Fargo analysts agree. While they think a default is unlikely, they wrote on Monday, "the rekindled debate will likely increase volatility in both fixed income and equity markets."
Volatility is key: A volatile market is bad for traders because it makes it harder to predict and manage risks effectively.
Wall Street typically uses the VIX, known as the market's "fear gauge," as a way to measure how investors feel about financial and economic uncertainties.
The S&P 500 and VIX typically move in opposite directions because a low VIX means calm and steady markets. However, when they move together, it suggests that the markets might be preparing for a sharp swing in one direction. That's exactly what happened on Monday. The VIX was up 0.5% and the S&P 500 gained 0.3%.
Year-to-date the index is down more than 20%, which would generally indicate optimism in the market. But over the past month it has climbed about 8.5%.
How to play it: Invest in equities from developed markets outside of the United States, said Michelle Wan and Mary Anderson, analysts at Wells Fargo. In US markets, stick with relatively safe, large-cap stocks for now, they added.
By 2024, markets should be less volatile, they say. For now, it's just about hunkering down and getting through the choppy second half of 2023 unscathed.
Still, during the debt ceiling standoff in 2011, the market declined, but rebounded very quickly, said Brad Bernstein, managing director at UBS Wealth Management. "We view any near-term pullbacks as buying opportunities," he said.
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