Debt-Ceiling Deal Is Close. Why Recession And Stock-Market Drop Will Follow.

Stock market worries over the debt limit have caused the stock to be on edge. However, an 11th-hour agreement that will avoid default is taking shape. Don't expect a huge relief rally, as aggressive Fed tightening along with the end of fiscal giveaways is likely to push the U.S. into recession by the end this year.

Rocket fuel, easy money, and excessive government spending, which propelled the GDP, inflation, and for a time, the stock exchange, is almost gone. A fiscal reckoning will soon begin. Washington will also have to deal with the budget for 2024 and the end of student loan payment holidays.

This will result in a further slowdown of spending at a moment when the growth has already slowed to almost a standstill. After five percentage point rate increases, the Federal Reserve may even step up the brakes.

All these factors suggest that the U.S. economic situation will be rocky in the second half 2023.

Investors will only experience a temporary relief from the debt ceiling because stock markets are about to lose their own fiscal support.

In recent months, the Fed's efforts to tighten conditions have been more than offset by Treasury's inability of issuing debt. This was due to assets that were purchased during Covid-19. Treasury debt issuance will increase following the agreement to raise the federal debt ceiling. This means that the Fed is about to go on steroids with its quantitative tightening.

Discussions on the Debt ceiling, 2024 Federal Budget

Negotiations on the debt ceiling could be due to end as early as June 5. Reports indicated that the deal emerging for a debt ceiling hike of two years would reduce spending by far less than what House Republicans had proposed. The cuts, instead of reducing discretionary spending to levels in 2022, would keep non-defense spending at levels slightly below 2023, and exempt military and veterans health expenditures.

White House is resigned to modest discretionary cuts in order to reach a deal on debt ceilings. Even if Biden tried to do a last-minute end run, such as declaring the debt ceiling itself unconstitutional, he would still need the GOP controlled House to approve the budget for 2024 before the new fiscal period begins on Oct. 1.

If that fails, the government may shut down until a deal is reached on spending. The last partial government shutdown, under the former president Donald Trump, resulted in a grounding of air traffic and delayed paychecks for over 800,000 federal employees, contractors, and others. Repeating this scenario would increase the risk of a U.S. economic recession.

Between the deadline for debt ceilings and September 30 -- zero hours for a federal budget agreement in fiscal 2024 -- another time bomb is lurking. Biden's $400-billion student loan forgiveness program is facing a Supreme Court decision in late June. Biden is likely to be disappointed with the result. Recent rulings by the conservative-dominated court show little patience for government agencies to adopt consequential policies without the explicit consent of Congress.

Borrowers could be affected by a ruling that rejects Biden's plan to forgive federal student loans up to $20,000. Biden has set an Aug. 31 deadline for lifting a three-and-a-half-year moratorium on student-loan payments.

According to the Committee for a Responsible Federal Budget, the government has lost more than $5 billion a month in interest due to the halting of student loan payments for approximately 40 million borrowers.

This is a gross understatement of the impact that the student loan payment pause, which benefited consumers by $1.3 trillion and a median balance $18,773, has had on their finances.

Thomas Simons, an economist at Jefferies, notes that the average monthly student loan payment for borrowers was $393 before the pandemic. Jefferies estimates that the end of the freeze will result in a 0.6% drop in aggregate personal income.

Simons, IBD, said that consumer balance sheets have already been exhausted.

He said that with the pressure of ending the student loan holiday, the consumer spending will "rollover significantly" in the second half.

The U.S. economy is also affected by other fiscal drags

The U.S. economy seemed to be revving up again at the start of 2023, after avoiding recession fears in 2020. The Fed responded to this by becoming even more hawkish. The Fed responded by becoming even more hawkish.

The last two Covid-era household financial aids are now past their expiration dates. Recently, emergency SNAP benefits (Supplemental nutrition assistance program) expired. This amounted in a monthly hit of $95 for households eligible, or nearly 50 billion dollars per year. Medicaid income limits that were suspended during the Covid pandemic are returning. A Kaiser Family Foundation study found that up to 17,000,000 people could be kicked out of Medicaid over the next 12 months, forcing them to purchase more expensive insurance.

Covid-19 Pandemic - Era Giveaways

The impact of ultra-low interest rates and fiscal giveaways during the pandemic era on household finances cannot be overstated. Federal Reserve study finds that three rounds of stimulus checks and unemployment benefits more generous than most paychecks combined with expanded child tax credit helped Americans accumulate $2.3 trillion by the end of summer 2021.

New York Fed reports that a massive mortgage refinance boom has reduced average monthly payments for 9 million families by $220. The New York Fed says that another 5 million took advantage of lower interest rates and rising home values by taking cash-out refis worth $430 billion.

A New York Fed report estimates that in the first two-years of the moratorium student loan borrowers received $195 billion in payments waived. This suggests that the amount has grown to $300 billion.

Fiscal Fuel for Inflation Surge

All of this helps to explain why the U.S. economic has been able to withstand 500 basis point hikes in Fed rates -- double the tightening level that was unsustainable during the previous cycle. It also explains the sudden vulnerability of the economy to recession.

This massive increase in savings, even though consumers were spending and paying down debts, combined with supply-chain disruptions caused by pandemics triggered an inflationary spiral. Businesses were able to raise wages and profit margins because consumers had such a high level of spending power.

The hiring rate remained high because wage increases helped sustain a robust demand. Plus, as households began to spend their savings down, they accumulated credit card debt in the face of high inflation and rising interest rates.

The biggest inflation surge in 40 years will result in the largest Social Security cost of living increase since 1981. As the labor market was still tight, employers also gave employees a second round of large pay increases.

But that cycle is now over. In the fourth quarter 2022, consumers had already shifted. The desire to spend drove the savings rate to 3% by September 2022, down from 8% to 9% before the pandemic. This boosted consumption by $1 trillion per year. The savings rate increased to 4.1% by April as caution crept in.

Richard de Chazal, economist at William Blair and Richard de Chazal, estimates that the consumers have already spent over 75% of what they had saved during the pandemic.

After a COLA induced income boost to begin the year, retail sales have been trending lower for the past three month, falling about 1% from January's levels in April. Walmart (WMT), and Home Depot HD, which both announced large minimum-wage increases early in the year have seen consumers taking a step back. Walmart CFO John Rainey cited reduced tax refunds and the ending of emergency SNAP as factors.

Businesses change their spending plans

The business world has also changed. According to Challenger Gray, the outplacement firm, corporations announced 337,000 planned job cuts in the first quarter of 2023. This is a 300% increase from the same time period last year. Labor Department data show that the number job openings dropped by 1.6 millions in Q1. This is the largest drop in data since 2001, except for the April 2020 pandemic lockdown.

The National Federation of Independent Business small business optimism index has reached its lowest level in over a decade. Nearly a third of small businesses say they are dependent on bank loans at a moment when short-term loans have an average interest rate of 8.5%, up five percentage points since March 2022.

High borrowing costs will likely force small businesses to reduce their largest expense: employees.

The businesses are responding to the 500-basis-point increase in interest rates that occurred over the last 14 months. This alone would have been enough to send the economy into a recession. But they also face a credit crisis, wrote Ian Shepherdson.

Shepherdson criticizes Fed hawks who are looking to raise rates further because inflation hasn't dropped fast enough. He says that the Fed has done enough and that a failure of rates to be cut very soon will "amount to overkill."

One can argue that the U.S. is heading for a soft landfall. Infrastructure spending and business investments are on the rise, even though government support from the pandemic era may be nearing its end. Under President Biden, three large spending packages could pump $1 trillion in earthmoving projects within a decade.

Jefferies Simons is skeptical that spending ramps on green energy, infrastructure and chip plants will be enough to keep up with the demand before it dwindles and layoffs increase.

Others argue that the consumer sector is strong enough to support the U.S. economic growth.

Doug Peta is the chief U.S. Investment Strategist at BCA Research.

Peta stated that "we do not see any obstacles to credit that prevent households from maintaining their consumption growth by taking on additional debt".

The end of the moratorium on student loans could change the game for consumers while intensifying problems for banks. New York Fed data show that even without student loan obligations, the delinquency rate for auto loans and credit cards has risen to levels seen before the pandemic.

Delinquencies tend to be highest among younger borrowers who are most likely to have student loans on forbearance. Delinquencies can spike once payments are resumed.

Wildcard Student Loan

The uncertain fate of the student loan relief has complicated the outlook for both the U.S. stock market and economy.

The White House is prepared to act even if the Supreme Court rules against student loan forgiveness. According to the Congressional Budget Office, Biden's Plan B of limiting repayment based upon income would cost $230 billion. This plan could be tangled up in legal battles, even though it might reduce the economic impact once the moratorium is over.

This raises the question of whether Biden will let the moratorium expire on time, or risk a backlash from younger voters, who are his strongest supporters.

Stock Market Rally Faces "Liquidity storm"

The S&P 500 closed last week at its highest level since August on the back of hopes for a deal to raise the debt ceiling. It is not a cause for concern that these gains are evaporating as the deadline approaches without a deal.

If history is any guide, investors should expect a larger stock market decline. The S&P 500 rose a few months before the deadline for 2011's debt limit. The stock market fell before the deal and continued to fall as soon as the ink was dry. The S&P 500 dropped more than 10% over two weeks around the August 2 debt ceiling agreement.

It is unlikely that the stock market will repeat its recent decline, but it could take some financial stress to get debt ceiling negotiators on board.

Investors have good reason to be concerned about the immediate consequences of a deal on a debt ceiling, as it could lead to bursting of the dam that prevents Treasury issuance.

Simons writes that the increase in Treasury issuing "is likely" to make matters worse for regional banks who are competing with high yields on bonds while trying to minimize deposit flight. This could lead to a tightening up of lending standards.

Barry Knapp, of Ironsides Macroeconomics, told clients via audio that he believes the S&P 500 will fall as low as 3,850 when the Fed's quantitative tightening ends abruptly.

He said: "We are on the brink of what I would call a liquidity hurricane."