Investor Pessimism Grows Without a Debt Ceiling Deal, Boosting Volatility

Equities are down for the third consecutive day as investors grow increasingly worried about continued brinkmanship in Washington over raising the debt ceiling. With just eight short days until the June 1 deadline recognized by Secretary of the Treasury Janet Yellen as the point at which the U.S. would default on debt, meaningful progress on reaching a deal has been hard to come by for negotiations. While leaders from both parties have at times attempted to strike a positive tone by calling talks productive and effective, an actual agreement that will spare investors’ from further pain is no where to be found.

Rather than increasing spending in the next budget, Democratic President Joe Biden has proposed a spending freeze and limits on future fiscal-year spending increases, while Republican House Speaker Kevin McCarthy has emphasized that spending in the coming years must be reduced significantly. In the meantime, Republican plans to cut spending will likely lead to a sharper downturn in the second half of this year as the economy transitions from a period of robust fiscal spending towards austerity. Republicans, for their part, believe spending must be reduced to address the country’s growing debt, which they believe is unsustainable at $31.4 trillion. McCarthy continues to reference the budget health of a typical household when speaking to negotiators and the public, as he emphasizes that the nation needs to move towards a balanced budget, where revenues and expenses shift into improved alignment.

Equities are down for the third consecutive day, as a failure to strike a deal will lead to an immediate recession. Investor pessimism is propping up volatility as traders pile on wagers to protect against potential downside with the Volatility Index (VIX) up 10.7% to 20.51. All major U.S. equity indexes are down close to 1% as the S&P 500 Index attempts to remain above meaningful support at the 4100 level; the Index is currently at 4118 as buyers took a stand, propelling it off this morning’s low of 4106. Bond yields are modestly higher across the board, led by debt ceiling fears and expectations of a tighter Fed with investors placing the odds of a 25-basis point (bp) hike at next month’s meeting rising to 32%. The 2-year Treasury yield is up 3 bps to 4.31% while the 10-year is up 1 bp to 3.71%. A disciplined Fed persists in supporting the dollar as the greenback continues to gain momentum from its April low of 100.8. The Dollar Index is up 30 bps to 103.78, a meaningful gain in the last few weeks. Crude oil is up strongly again, a day after Saudi Arabian Oil Minister Prince Abdulaziz bin Salman told oil shorts to “watch out,” reflecting a bullish outlook from the Kingdom’s oil ministry. WTI crude oil is up 2.1% to $74.42 per barrel.

Recent earnings reports illustrate the benefits of mortgage interest rates stabilizing in the first quarter (they have since started to increase), while consumers have struggled with higher costs of living. Corporations, meanwhile, are continuing to spend on technology that makes their operations more efficient. These themes are illustrated by the following examples:

• Toll Brothers reported net income of $320.2 million and earnings per share (EPS) of $2.85 on a diluted basis for its fiscal second quarter ended April 30 compared to net income of $220.6 million and EPS of $1.85 for the same period last year. Results for the most recent quarter beat the analysts’ expectation of $1.89. The company’s revenues from home sales of $2.5 billion increased 14% from the year-ago quarter and the average home sale price was $1 million. Toll Brothers Chairman and Chief Executive Officer Douglas C. Yearley, Jr. said a decline in mortgage rates helped spark increased demand for homes during the quarter. Many existing homeowners, furthermore, want to hold on to mortgages with extremely low interest rates so they are reluctant to sell their homes, which is contributing to demand for new homes. In a sign of Toll Brothers’ confidence in the housing market, the company has increased its inventory of spec homes, or homes that are built on speculation that they will sell quickly rather than having committed buyers prior to starting construction. Yearley believes strong demand for housing will continue because new home construction hasn’t kept up with the country’s population growth during the past 15 years, creating a substantial shortage of homes. Its shares are up 2.2% on the news.
• Kohl’s, which operates department stores, posted first-quarter EPS of $0.13, matching the EPS for the year-ago quarter but substantially beating the consensus estimate of a $0.44 loss per share. Kohl’s revenue of $3.35 billion declined from $3.47 billion year-over-year (y/y) but exceeded the consensus expectation of $3.3 billion. Kohl’s Chief Executive Officer Tom Kingsbury said the company has shifted its focus away from discounts to clear inventory and is now focusing on products that have higher demand, such as work clothing. Nevertheless, comparable sales declined 4.3% y/y while analysts were expecting a 3.9% decline. Kingsbury said inflation has increased the cost of living for consumers, which has resulted in a decline in discretionary spending. Its shares were up as much as 17% on the news before cooling off to up 6%.
• Palo Alto Networks, which provides cloud-based cyber security, reported EPS of $1.10 on an adjusted basis for its fiscal third quarter ended April 30. The EPS climbed from $0.60 in the year ago quarter and beat the consensus expectation of $0.93. Its net income of $359.4 million climbed from $193 million y/y. The company’s revenue of $1.72 billion met consensus expectations and rose 24% y/y from $1.38 billion. Revenues benefited from the company increasing its number of large clients and a trend of businesses consolidating purchases of Palto Alto products. Palo Alto estimates that its current quarter EPS will reach $1.28 and revenues will reach $1.95 billion. Analysts estimate the current quarter EPS will be $1.20 and revenues will be $1.95 billion. Its shares are up 8% on the news.

As investors assess the political outlook in Washington, a failure to secure a deal in time will lead to dire consequences which will hurt the vulnerable portions of the population most. With the possibility of social security checks not being mailed out, or funds for food support not being released, the absence of a deal will lead to very difficult choices. From a financial market perspective, millions of job losses will lead to deteriorating consumer sentiment and spending, at a time when the economy is already endangered. Corporations will have to prove their resilience once again if these negative developments cascade, as margins come under pressure due to contracting spending amidst persistent cost pressures.

Contribute by Interactive Brokers, Author: Jose Torres