myICLUB Blog


The Debt Ceiling Issued Is Settled (for Now)


What About Interest Rates?

Stock and bond market behavior suggested there was little concern about the chance of a federal default. But raising the debt ceiling doesn’t really solve the underlying problem—tax collections have gone way up but spending has risen even faster. While we can ultimately pay our debts by printing money, the result would likely also involve higher inflation.

Since World War II, federal government revenue has averaged 16.8% of Gross Domestic Product, and spending has averaged 19.3% of GDP. In Fiscal 2022, revenue reached 19.2% of GDP, the second highest level since WWII and almost identical to the average spending level. However, spending grew to 24.6% of GDP, the third highest level since WWII. The budget deficit of 5.4% of GDP was more than double the postwar average.

Some of this spending is related to the pandemic and will recede. However, tax collections are also receding as outsized capital gains collected during the market’s surge in 2020 and 2021 return to normal. April’s tax receipts were lower than expected due to reduced capital gains, causing Treasury to accelerate its initial estimate for exceeding the debt ceiling from July to early June. Ultimately, this is a matter for voters to address at the ballot box. No matter how it is addressed there will be consequences for the economy and for investors, but the outcome depends on the direction chosen by the electorate.

As this tension escalates, another drama may be receding at least for now. The Federal Reserve voted in early May to raise interest rates for the tenth consecutive time, this time by 25 basis points (0.25%). There are indications the Fed may pause its rate hikes for a while to allow the “long and variable lags” from previous hikes to take effect. This means it takes some time for interest rate changes to work their way through the economy.

In the policy statement accompanying the May rate hike, the Fed eliminated a phrase used in previous statements that “additional policy firming may be appropriate.” While Fed Chairman Jerome Powell stated that no commitment had been made to pause rate hikes, removing that phrase implies a consensus to that effect. In statements and speeches following the meeting, one Fed governor was clearly in favor of continued hikes, two more were strongly in the pause camp, and at least one influential Fed governor stated he was “comfortable” with market expectations of no increase at the June Fed meeting.

Meanwhile, the U.S. economy appears to be growing, although at modest rates. First quarter Gross Domestic Product grew at a 1.1% annualized rate. Growth in consumer spending was strong, but falling business inventories and capital investment implied concern over the future. Retail sales have been soft for three of the past four months. Over the past year, retail sales growth of 1.6% is far below the 4.9% inflation rate. Overall consumer spending has been stronger as consumers shifted their focus to services (like travel and dining) over the past year even as spending on goods has moderated.

While the economy created an impressive 253,000 jobs in April, the impact was muted by a 149,000 reduction in previous job-growth estimates for February and March. The unemployment rate remains at the all-time low of 3.4% reached several times in history.

U.S. inflation has gradually receded, but not yet enough for the Fed to firmly believe it has done enough. Interest rates were still below near-term inflation guesses of 3%-4% as recently as late 2022. This means monetary policy was still “accommodative,” meaning that it was boosting inflation rather than fighting it. Interest rates are believed to impact the economy with lags of at least 6-9 months. We are now six months past the time when monetary policy became restrictive so the effects of past rate hikes should increasingly become visible in the economy through reduced business investment and household spending, particularly on big-ticket items that are frequently financed.

The stock market has historically reacted strongly to the cessation of rate hikes, and stronger yet when interest rates are eventually cut. Much of the market strength this year may be an attempt to invest ahead of eventual rate cuts, but no Fed governors have voiced a belief that rates could actually decline in 2023.

Investors need to be nimble given the risks of Fed actions, a possible recession, and the unpredictable nature of debt ceiling discussions. Excellent opportunities might present themselves. With investors potentially looking ahead to eventual improvement in the economy, valuations don’t appear particularly cheap. However, a significant part of investing success is simply having the courage to hang in there and not assume any of us are smarter than the collective wisdom of millions of investors, but trusting the long-term wealth-building power of investing in quality growth stocks.

In this issue, our analysts focus on a small cyclical manufacturer of truck components, a midsized entertainment company, and a midsized business services company. Each feature the quality metrics we demand and are selling at share prices that can deliver our desired level of capital appreciation.

The commentary has been excerpted from the issue of Investor Advisory Service published in late May. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 13th consecutive year for outperforming every up and down market cycle since 2002.

For more information about the Investor Advisory Service, to download a sample issue, or to subscribe to the best investing newsletter in the U.S. for long-term consistent returns, visit Investor Advisory Service.