Debt ceiling deal may shift investor focus to further Fed action

A view of the U.S. Capitol building in Washington

By David Randall

NEW YORK (Reuters) - A last-minute deal to raise the U.S. $31.4 trillion debt ceiling will likely shift Wall Street's attention to other emerging risks, including further Federal Reserve interest rate hikes and an expected reduction in fiscal spending.

At its May 3 meeting, the Federal Reserve signaled it was open to pausing its most aggressive rate hiking cycle since the early 1980s at its meeting that ends June 13, leading investors to pile back into equities and other riskier assets.

The S&P 500 is up more than 9.4% for the year to date and now trades at nearly 19 times its forward earnings, at the high end of its historical range. Megacap technology and growth stocks, which benefit from lower interest rates, have led the market's advance.

"There has been a pivot party in equities, which is this idea that Fed will pause and reverse course that has rewarded risk assets," said Emily Roland, co-chief investment strategist at John Hancock Investment Management.

"We think that there's limited upside from here."

Since May 3, Dallas Federal Reserve Bank President Lorie Logan and St. Louis Fed President James Bullard have said that inflation does not appear to be cooling fast enough.

Unexpectedly strong economic data on Friday appeared to bolster their case, with underlying core inflation at 4.7%, up from 4.6% in March and well above the Fed's 2% inflation goal.

Markets are now pricing in a roughly 50-50 chance that the Fed raises rates by another 25 basis points at its June 14 meeting, up from an 8.3% chance seen of an expected rate hike one month ago, according to CME's FedWatch Tool.

A Congressional package raising the debt ceiling, meanwhile, is expected to cap spending on government programs.

That, combined with the possibility of higher interest rates to cool inflation, could help push the U.S. economy into a recession despite ongoing strength in the labor market, said Tony Rodriguez, head of fixed income strategy at asset manager Nuveen.

"We expect to see a slowing economy because a number of what had been tailwinds are becoming headwinds."

The U.S. economy has remained unexpectedly resilient, given widespread expectations at the end of 2022 that it would be in recession by mid-year. Investors will be closely watching next Friday's jobs report to gauge the ongoing strength of the labor market and potential for consumer spending.

And overall, analysts are expecting the S&P 500 to reflect earnings growth of 1.2% in the third quarter and 9.2% in the fourth quarter, according to Refinitiv.

While those estimates may be boosting investor sentiment now, signs of economic strength may leave inflation higher than the Fed would like, prompting more rate hikes, said Josh Jamner, investment strategy analyst at ClearBridge Investments.

"It's a pick your poison moment," he said. "If we get a soft landing that puts stock multiples at risk due to the Fed raising rates, and if we get rate cuts it means that the economy has fallen into recession."

The debt ceiling impasse had weighed on stocks in recent days, but for the most part investors had been expecting Washington to reach a deal. That means a sustainable relief rally is unlikely in the equity market, said Roland.

At the same time, the equity market has only just begun to start pricing in more Fed hikes, she added.

Higher rates over the second half of 2023 will keep pressuring companies that issued debt during the pandemic era of ultra-low rates, and they will need to either pay it off or refinance it, said Bryant VanCronkhite, a senior portfolio manager at Allspring Investments.

Some $6.5 trillion issued in 2020 and 2021 will mature by 2025, according to S&P Global Ratings.

"The ongoing effects of monetary policy now are setting us up for this wall of debt that people aren't talking about with enough vigor," he said.

(Reporting by David Randall; editing by Michelle Price and Richard Chang)