MIKE TOWNSEND: Over the past week or so, investors have been inundated with talk of one thing: the looming debt ceiling fight in Congress.
With the announcement last week that the United States has hit the debt ceiling and that Treasury is employing what it calls "extraordinary measures" to ensure we don't default, there have been lots of expressions of doom and gloom―that we are heading for an economic and financial disaster.
But is that true? How might this play out? And how worried should investors be?
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.
On today's episode, I want to look more closely at what the debt ceiling fight is all about―and whether all the fuss is warranted. And I want to explore some of the more immediate issues that investors are focused on, like the recent inflation numbers and the mixed results so far from the current earnings reports. To help me sort through that, I'll be joined in just a few minutes by Randy Frederick, Schwab's managing director for trading and derivatives, someone who's got a real sense of what investors are thinking about.
But first, a quick look at what's making news in Washington.
On Capitol Hill, it's been relatively quiet after the chaos of the opening week of January and the 15 votes to elect a Speaker of the House. Both the House and Senate were on recess for the week of the Martin Luther King holiday and have now returned to Washington to focus on getting themselves organized. Committee assignments are being finalized, and committees should be up and running with hearings and legislative activity in the next week or two.
One notable change is that the House Financial Services Committee has created a new subcommittee focused on digital assets and financial technology. This is the first time that there's been a Congressional subcommittee devoted to the cryptocurrency space, and I think it's indicative of the level of interest on Capitol Hill in creating a better regulatory structure for cryptocurrency. The panel will be chaired by Congressman French Hill, a Republican from Arkansas currently serving his fifth term in the House. Hill has a lengthy background in financial services and economic policy, having spent more than two decades as a commercial banker and investment manager in Arkansas. Earlier in his career, he served as a staffer on the Senate Banking Committee, on the president's National Economic Council, and at the Treasury Department. Congressman Hill has been a crypto champion who has said a better regulatory structure is needed to help digital assets and other financial technologies flourish over the long term. The new subcommittee is going to be something to keep an eye on, as interest in crafting a cryptocurrency bill remains quite high in Congress.
Elsewhere, another tax season is upon us. The IRS officially started accepting individual returns this week and taxes are due on April 18 this year. The IRS is expected to be in the spotlight as the agency tries to improve customer service and speed the processing of returns after a couple of terrible years in both areas. Last year's Inflation Reduction Act provided the IRS with an additional $80 billion in funding to improve collection. The agency has used some of that money to hire 5,000 customer service agents who are in place to answer the phone and respond to taxpayer questions during this tax season. Of course, that funding is a huge point of contention on Capitol Hill, where the very first bill that House Republicans approved this year was legislation rescinding that $80 billion in funding. Now, while that bill won't be taken up in the Democrat-controlled Senate, we can expect House committees to scrutinize the IRS performance in hearings throughout the year ahead.
But the issue that has been the subject of far and away the most chatter in Washington over the last couple weeks has been the debt ceiling. With the seemingly non-stop talk about the potential for triggering a financial catastrophe this summer, I thought it would be helpful to run through a bit of the background.
The debt limit, or debt ceiling, is the cap mandated by Congress on the total amount of debt the United States can accumulate. The current cap of about $31.4 trillion was set in December 2021 by the last Congress.
On January 19, the U.S. hit that cap, meaning that the government no longer has the authority to borrow. Treasury Secretary Janet Yellen, in a letter to Congressional leaders, said that the department would begin taking what it calls "extraordinary measures" to ensure the United States does not default. Initial steps include temporarily suspending new investments in various retirement plans for federal employees, and then making up the difference once the debt ceiling is raised.
This is not unusual―Treasury has employed these measures about a dozen times over the last couple of decades. These steps buy Congress time, usually several months. In her letter last week, Secretary Yellen told Congress that a combination of cash receipts and extraordinary measures should ensure that the government avoids default until at least early June. Third-party analysts have said that the default date is likely to come in late June or even early July.
While the exact date is unknown, the clock is now ticking toward default and the pressure is on the deeply divided Congress to act. Lawmakers will need to either raise the debt ceiling to a new amount or suspend the debt ceiling for a specific time period. In recent years, previous Congresses have taken both approaches.
There's been lots of talk over the past week or two about how this could be the most contentious debt ceiling debate Congress has ever faced. The lines in the sand are already being drawn. Republicans, who control the House of Representatives, say they won't approve a debt ceiling increase unless it is paired with a corresponding amount of spending cuts. Democrats, who control the Senate and the White House, say they will only support a "clean" debt ceiling increase, with no strings attached. The contours of an epic standoff are in place.
Interestingly, the talk on Capitol Hill about the debt ceiling has started much earlier than usual. Late last week, President Biden and new House Speaker Kevin McCarthy agreed to meet to discuss the issue, though no date for that meeting has been set yet. That's an indication that both parties know this won't be easy and that getting those conversations underway sooner rather than later is important.
But of all that has been said about the debt ceiling over the last couple of weeks, the comment that most interested me came from the Senate Minority Leader, Mitch McConnell. Speaking in his home state of Kentucky last week, McConnell said, "I think the important thing to remember is America must never default on its debt. It never has and it never will." He went on to say, "I would not be concerned about a financial crisis."
McConnell's comment, for me, goes to the heart of the matter, which is that two things can be simultaneously true: One, that this could indeed be the most contentious debt ceiling debate ever. And two, that Congress will eventually find a way to raise the debt limit, just like it always does.
I continue to think the chances of an actual default are relatively low. While it won't be a straight line to get there, there is a large majority on Capitol Hill that recognizes that a default could cause unprecedented damage to the global financial system and the global economy. They will eventually want to find a way to raise the debt limit.
There is even a process called a "discharge petition" whereby a small handful of Republicans could join with Democrats to force a vote on a debt ceiling increase in the House of Representatives. It's a cumbersome and time-consuming process, but it could be a back-up plan if talks bog down.
On my Deeper Dive section, I want to explore how the market may react to the debt ceiling battle, as well as dig into some of the other issues impacting the markets right now, including the most recent inflation numbers and the beginning of earnings season. For perspective, I'm happy to welcome back Randy Frederick, Schwab's managing director for trading and derivatives. Randy, thanks so much for joining me today.
RANDY FREDERICK: Great to be here, Mike.
MIKE: Well, let's keep things going on the debt ceiling discussion. Even though it is not likely to cause big issues in the markets for several months, it's in the headlines much earlier than usual this time, and I think that's because of concern about how this polarized Congress will be able to address it. Bond investors are already showing their concern and are selling bonds that mature in mid- to late summer at a discount, producing rising yields in those bonds. The most obvious corollary we have is the summer of 2011, when the U.S. came the closest it has ever come to defaulting on its debts. Interestingly, we have the exact same political configuration in Washington now that we had in 2011―a Democrat in the White House, Democrats holding a slim majority in the Senate, and Republicans holding the majority in the House of Representatives. But it's easy to make the case that things are even more polarized today. So maybe we could start with a look back at what happened in 2011?
RANDY: I think you're right, Mike. 2011 is probably the best example we can recall where the debt ceiling issue really rattled markets. As you stated, the Republicans, having just taken over in the midterms as the majority in the House, decided to flex their fiscal muscle by demanding substantial spending cuts from President Obama before they would agree to raise the debt ceiling. While the actual ceiling was reached in April of that year, then Treasury Secretary Timothy Geithner, resorted to "extraordinary measures" to keep the government operating for a few more months.
But by August when the Treasury estimated that the government would run out of money, Standard & Poor's downgraded the U.S. credit rating from AAA to AA+, carrying through on the warning it had issued in April. The downgrade occurred despite passage of the Budget Control Act of 2011, which raised the debt ceiling only a couple days before the deadline was reached.
As you already know, markets did not react well to the political brinkmanship or the credit downgrade. From early August through early October, the VIX index had spiked above 40 several times, and from early July through early October, the S&P 500® fell 18.8%. Fortunately the markets eventually calmed down, rallying back about 10% by the end of October, and 2011 as a whole finished just about unchanged. Not a great year compared to the 12.8% gain in 2010 or the 13.4% gain that would occur in 2012, but a solid recovery from the brink for sure. But to this day, Standard & Poor's credit rating of the U.S. remains at AA+.
MIKE: Well, that's interesting, Randy. If this scenario plays out again in 2023, and the U.S. credit rating is downgraded another notch, do you think it's likely to stay at that next lower rating? As you say, that's what happened last time, and it has not moved back in the 12 years since.
RANDY: That's a great question, Mike. The other two big credit agencies, Fitch and Moody's, have both threatened a downgrade a few times, but both still have the U.S. as AAA, so it's really only S&P that maintained their downgrade. I would think the answer to your question depends on how far the House is willing to push the issue. I honestly do not know where exactly that line is; I just hope we don't find out. If a downgrade were to occur, I would think it would last at least until the next general election in 2024, and even then, it would probably depend on the outcome of the election.
MIKE: Well, hopefully we don't get to that point. I think what investors want to know is, can we look at 2011 as a model for what could happen if Congress gets stuck in an extended standoff this year? Do you expect that kind of volatility and disruption to the markets? And maybe most importantly―is there anything that investors should be doing to prepare?
RANDY: Unfortunately, I do think 2023 has the potential to be just as damaging. We're already 12 months into a bear market, and some of the existing or newly elected representatives seem to be willing to risk calamity if necessary in order to extract spending cuts from President Biden.
Obviously, we don't know if they'll push it that far or not, but just the threat of doing so may be enough to push an already fragile market into a much worse position.
At the moment the S&P 500 is only about 10% above the lows it reached last October, and this is the only bear market since the VIX was first created back in 1993 in which there's been no panic spikes above 40, either intraday or closing. Now I don't necessarily think that has to happen, but if 2011 is any guide, an eleventh-hour showdown on this debt ceiling issue could be a catalyst strong enough to do it.
For investors worried about how to prepare for this potential showdown, there are many ways to try to hedge. But I would caution that any strategy used to protect the downside will either be very expensive or require a total forfeiture of any upside potential that could result if a showdown is averted or quickly resolved. While nothing is guaranteed, and it may be uncomfortable in the short term, sometimes just holding on for the long term is the best alternative. Unless, of course, you really believe the U.S. would default on its debt.
MIKE: You know, Randy, as you mentioned a moment ago, the market rebounded fairly dramatically in 2011 once the debt ceiling impasse was resolved. So if that scenario plays out again this year, I think it's going to be tricky to try to time the market exactly right. You'd really need to time it right twice―once to make the right moves ahead of a potential debt ceiling-related downturn, and once to know when to move back in once the situation is resolved in order to catch a market rebound. That's why your last comment―about just holding on for the long term―may be the right way to go.
Well now, Randy, let's switch gears to the economy. Over the last couple of weeks, we've had both the CPI and the PPI numbers come out, which show inflation continuing to slow. So what are your takeaways from the latest numbers? It seemed the markets had priced in the recession, and there was an upturn, but now things are sliding again. So is there more to the story?
RANDY: Indeed, the inflation metrics have been falling across the board, exactly what the Fed has been trying to accomplish since it began hiking interest rates back in March of last year.
At 6.2%, the headline December Producer Price Index, or PPI, eased quite a bit from the 7.3% level in November, and it came in well below the 6.8% estimate. The week before that, the headline December Consumer Price Index, or CPI, came in at 6.5%. While that was in line with the estimate, it was well below the 7.1% in November.
Now, just to be clear, neither of these reports are implying that prices are actually falling, just that they're rising more slowly than before. The year over year change in both the CPI and the PPI peaked back in June of last year, and they've been trending steadily lower.
The interesting thing is that the markets responded to the PPI by moving higher only for about 90 minutes and then heading sharply lower in the remainder of the day. The previous week, when the CPI was released, the markets just moved mostly sideways. Now both of those are a bit puzzling because a slowdown in inflation should have been perceived as good news for the equity markets, since it means the Fed's rate hikes are taking effect. That's especially true when it is accompanied by continued strength in the labor market.
MIKE: Well, that is interesting. Why do you think the markets have reacted this way to the CPI data?
RANDY: You know, I can only speculate here, but I suspect that fears of a deeper, more protracted recession may now be overshadowing inflation fears. And I think this helps illustrate just how much of a tightrope the Fed is trying to walk in engineering a soft landing.
MIKE: You know, when you're thinking about the Fed, there seems to be a growing consensus that the Fed's aggressive rate hikes over the last year are working, at least in the sense that the economy seems to be cooling and inflation is continuing to slow. But the flip side of that is that big companies keep making headlines by announcing layoffs―such as Microsoft's announcement last week that they are laying off more than 10,000 workers and Google's decision to lay off 12,000―and retail sales are slowing, indicating that consumers are reducing their spending as the Fed's policies start to hit their wallets more directly. But isn't that what the Fed wanted to happen? How do the markets feel about it?
RANDY: While employee wages tend to be one of the largest expenses for any company, most companies try to avoid layoffs for as long as possible when budgets get tight. Layoffs usually involve severance packages and letting people go that you might need in a few months. That means you have to train their replacements all over again. And both of those things can be pretty expensive. Usually companies will cut temporary workers, overtime hours, and bonuses first, if possible.
Now these are some of the reasons why unemployment rates tend to be one of the most lagging of all the economic indicators. Most of the time, unemployment rates hit record lows just before a recession and don't peak until after the recession is already over. Right now, despite a bear market that's already in its 13th month, the unemployment rate is at a 53-year low. Though I would expect this to start to tick up a little bit higher in the next few months, just based on the number of layoffs that have already been announced in the tech sector. Easing inflation with only a modest impact on the labor market aligns fairly well with the Fed's "soft landing" goal, if that happens.
The jury is still out whether we'll have a recession in 2023 or not. If the debt ceiling issue gets resolved, inflation continues to decline, the Fed just holds interest rates steady, and unemployment doesn't tick up too much, I think it's still possible for the Fed to execute a soft landing. While never officially declared by the National Bureau of Economic Research, or the NBER, it's possible that the recession already happened in the first half of 2022. And while 2023 seems unlikely to set any records, a continued deterioration is not inevitable either.
MIKE: Well, the Fed's message has been that it fully expects to take the base interest rate to 5% and likely even a bit higher than that. They say that they want to make absolutely certain that inflation comes back down to their target level, but many investors are starting to worry that they'll go too far. And I think all investors are going to be watching carefully to see how this plays out in the months ahead.
Well, Randy, the other big thing that investors are watching right now is earnings season, and this is maybe the first earnings season that is really reflecting the impact of the Fed's policies. Now not too many companies have reported so far, but what are you seeing out there that investors should be paying attention to?
RANDY: Well, the unofficial Q4 earnings start date was back on Friday, January 13, and that's when many of the big banks such as Bank of America, Wells Fargo, JP Morgan Chase, and Citigroup kicked things off.
According to FactSet, throughout Q4, earnings estimates fell by about 6.5%; and that's far more than the average of 2.5% in most quarters. The sectors with the largest decline in estimates were materials, consumer discretionary, and communications services.
Now, as of Monday, January 23, only about 57, that's 11% of the companies in the S&P 500, had already reported Q4 results. When the quarter ended on December 31, the expectations were for a year-over-year aggregate earnings decline of about 4.1%; now, if that happened, that would be the first earnings decline since Q3 of 2020, which was a 5.7% decline. So far, Q4 earnings are down about 4.5% year over year, so just slightly worse than the estimate. And this compares to a gain of 3.8% year over year in Q3.
Expectations were also for only about a 3.8% revenue growth in Q4; that would be the lowest growth rate, if it happens, since Q4 of 2020, which was 3.2%.
So far, though, Q4 revenues are actually up about 7.4% year over year, so that's a little bit above the estimate. But that compares to a final growth rate in Q3 of 11.5%, so lower than that.
As you might imagine, inflation tends to cause top-line revenues to increase but bottom-line income to decrease. And, really, I think that's the reason for this disparity. While normally it's the results versus expectations that tend to drive markets, and that's kind of a bit of a mixed bag at this point. But it's still rather early in the season, so I wouldn't extrapolate those results just yet.
That said, 69% of companies that have reported Q4 earnings have actually beaten the expectations, and that's right in-line with Q3. But only 52% of them have beaten the revenue estimates; that's not only lower than Q3, it's the lowest since Q4 of 2015. And I think that implies that the inflation-related revenue boost was already baked into these estimates.
Now I usually recommend waiting until about a quarter of companies in the S&P 500 have reported, before you really have a good picture for how this quarter's going to play out. It's also safe to assume that the actual results may end up better than these estimates, because they almost always are. In fact, that's been true in 38 out of the last 40 quarters.
Perhaps most notable is that if not for the energy sector, these results would have been a whole lot worse. In Q4 alone, energy is expected to report a year-over-year earnings increase of 61%.
Without energy, Q4 year-over-year earnings growth would have been −8.2% rather than −4.1%.
Now that's true not just for Q4, but for the whole year, as earnings growth in the energy sector exceeded 150% for all of 2022. Every other sector had less than 30% growth, and, in fact, consumer discretionary, communications services, and financials were all negative.
MIKE: Yeah, that last point's a really important one. I think the outsized impact of the energy sector is a good reminder that it's always better to dig into the numbers a bit and not just focus on the headline number.
Well, finally, Randy, I can't let you go without a cryptocurrency question, as you are our resident expert. With the collapse of FTX in November, a lot of obituaries for the cryptocurrency space were written. And there have been other crypto companies in or on the very edge of bankruptcy. But, like Mark Twain said, reports of cryptocurrency's death seem to have been greatly exaggerated. Cryptocurrency enthusiasts seem undeterred―and even FTX reportedly is considering restarting under its new CEO. As the dust continues to settle from the FTX implosion, what's your take on the state of the cryptocurrency world?
RANDY: Well you're right Mike. I was a bit surprised to hear that the new court-appointed CEO of FTX, John Ray III, said he was exploring the idea of restarting FTX as a cryptocurrency exchange. That is a stark contrast to the way he described that company when he first arrived.
When he first appeared live before a House committee in mid-December, he testified that he believed Sam Bankman-Fried was guilty of diverting customer funds to support his hedge fund, Alameda Research, and just good old-fashioned embezzlement. He also said FTX had no accounting measures, no internal corporate controls, and no trustworthy financial information.
A few weeks ago, Mr. Ray said that he and various bankruptcy attorneys combed through the wreckage, and that they had located at least $5 billion in liquid assets, in other words not cryptocurrencies. But they will likely have to be liquidated slowly to avoid market disruptions.
That was on top of previous reports that federal authorities had already seized other less liquid assets, including approximately $450 million equity shares of broker Robinhood.
Now here's the problem: The original bankruptcy filing in November of last year listed over 130 entities as affiliates or partners, so any reimbursements to the more than $3 billion in unsecured creditors will likely take years to complete.
Many high-profile celebrities and businesspeople are included in that list, and here's just a short list: NFL star Tom Brady and his ex-wife supermodel Gisele Bundchen, New England Patriots owner Bob Kraft, a whole host of billionaire hedge-fund investors, Canadian businessman Kevin O'Leary, NBA star Steph Curry, and several others that were redacted from the publicly released filings.
There are also dozens of banks, lenders, and other crypto firms with claims in addition to an estimated 9 million customers whose assets are currently either lost or frozen.
Now I don't see how you can move from a company with no controls, no books and records, no valid data, to an operating exchange in only a few short months, while all of these creditors sit and wait. I suspect what Mr. Ray may have been alluding to was something that could happen many months, if not years, out into the future.
As we've talked about several times in the past, Mike, cryptocurrencies were born in the aftermath of the great financial crisis, when Wall Street and big banks were bailed out despite being heavily regulated and despite contending that they could be self-governed.
Now, despite all the proof that self-governance doesn't work—it didn't work on Wall Street back in 2008, it didn't work in the crypto industry in 2022—many idealistic crypto investors remain loyal to the cause. They just want to use money that's not controlled by the government.
I know you've heard me say this before: While crypto proponents often promote the benefits of decentralized finance, they tend to conflate the fact that most of the crypto industry is not in fact decentralized, just recentralized—from a central bank to a mostly non-regulated, non-government, bank-like entity like FTX. And we can see how well that went.
The one possible exception, ironically, is Bitcoin. Because its original code ensured that no more than 21 million bitcoins could ever exist, new coins can't simply be created by some company that calls itself an exchange; thus, it also can't be diluted. It is probably the closest to being truly decentralized.
Now, that doesn't mean I think Bitcoin is a good investment. It probably won't ever be a viable currency. It has value because people think it has value. Scarcity alone, though, does not make an item valuable.
So, for example, I don't have a whole lot of artistic talent, so if I painted 10 paintings and declared them valuable because I promised I wouldn't paint any more of them, it's doubtful that anyone would pay me much for them. While Bitcoin may not be at risk of going away any time soon, that also doesn't mean that it will increase in value.
I don't know for sure, but I suspect that there are substantial risks still out there and we just don't know about them yet. But despite the risks, there are millions of undeterred users, determined to stay in the game until they either get rich or broke, whichever comes first.
MIKE: Well, Randy, I always appreciate your thoughts on the crypto space, and thanks also for your insights on the other aspects of the markets we discussed today.
Really appreciate you taking the time to talk to me.
RANDY: You're welcome, Mike. Anytime.
MIKE: That's Randy Frederick, Schwab's managing director for trading and derivatives. He's a great follow on Twitter―you can find him @randyafrederick.
That's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks.
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For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
