This week in the podcast, we’re focusing on the debt ceiling. Two big things you need to know: First, we see debt ceiling drama as a contributor to choppiness in US equity markets later this year, though we ultimately expect a deal. This was a hot topic in our meetings with UK investors last week. Second, we see Health Care as one of the most vulnerable sectors in the short term but would be buyers on weakness.

If you’d like to hear more, here’s another five minutes. While you’re waiting, a quick reminder that you can subscribe to this podcast on Apple or Spotify.

Now, let’s jump into the details.

Let’s start with takeaway #1: we see debt ceiling drama as a contributor to choppiness in US equity markets later this year, though we ultimately expect a deal.

We spent last week in the UK speaking with equity and derivatives investors about our views on US equity markets. Surprisingly, the hot topic that most wanted to discuss was the US debt ceiling. This was true even before McCarthy’s bill passed the House on Wednesday.

Most of the investors we spoke with had a negative view on US equities and saw the debt ceiling as something that stood a reasonable chance of sparking a pullback in US equities in the coming months.

We don’t agree with our UK-based clients on their negative view of the US. Overall, we continue to feel neutral.

But the debt ceiling is one issue where we do find some common ground. In our discussions last week, we revisited the work we published back in late February (when we found it was difficult to get our NYC-based hedge fund clients to even pay attention, even though many of the long-only clients were asking about it). Our main conclusion remains that US equities have been highly sensitive to debt ceiling headlines in the past and have a role to play in getting Congress to come to an agreement.

First, the worst debt ceiling dramas for stocks occurred when angst was already high in financial markets for other reasons and total declines ranged from 10-19%. 2011’s 19% drop, for instance, occurred when fear regarding the European sovereign debt crisis was also high.

And the 10% drop in early 2018 occurred alongside the unwind of the low vol trade.

As well as 2019….

Back in February a 5-6% hit was the scenario we thought was most likely in 2023, but the loss of confidence from the recent banking crisis has increased the likelihood of a more significant breakdown of 10% or more. That’s not our base case, but its chances have risen in our minds.

And third, there were several instances in which the stock market didn’t react much to the first round of warnings on the debt ceiling, but sold off around the second wave of warnings. That feels like where we are today. Last week the investors seemed unnerved about the idea that the x date estimate was moving up. Tuesday, Yellen’s letter proved their fears were well founded when she indicated that the x date would be June 1st, even earlier than the July timing the investors we spoke with last week were talking about.

Moving on to takeaway number two: we see Health Care as one of the most vulnerable sectors to debt ceiling drama in the short term but would be buyers on weakness.

One question that kept coming up last week was what sectors would be most vulnerable in a debt ceiling-related drawdown. We referenced our February work in which we reviewed debt ceiling commentary in recent company press releases, transcripts, and filings (the footnotes of financial statements were surprisingly useful). That exercise indicated that Health Care was one of the sectors citing the issue as a risk factor most often. This was due to higher exposure to government spending programs, reimbursement concerns, and FDA/clinical trial exposure.

Industrials was another, mostly Aerospace & Defense companies, which exposure to government spending programs also highlighted.

Banks had been highlighting the issue in the context of the matter creating problems for financial markets.

To provide some additional context, we’ve taken a quantitative look at how the level of discussion on the debt ceiling today compares to the past. This work suggests to us that debt ceiling worries have spike for Corporate America.

In terms of sectors/industries, Health Care commentary has moved back to 2011 and 2013-2014 levels.

This was also true for Aerospace & Defense.

While we haven’t had a strong view on Aerospace & Defense companies and prefer to stay on the sidelines with Banks, the debt ceiling admittedly complicates our constructive view on Health Care. We have been overweight Health Care, and have been pointing out recently that the sector has become the most reasonably valued defensive sector in the S&P 500.

Other things we like about the sector have included constructive views from our analyst teams and the improvement we’ve been seeing in EPS revisions trends for the S&P 500 version of the sector. Given the higher level of risk disclosure, we suspect Health Care would not act defensively in a debt ceiling-driven drawdown. But given our expectation that a deal will eventually be reached and the reasonableness of current valuations for the sector, we’d use any debt ceiling weakness in the sector as a buying opportunity.

Before we wrap up – one last thought.

That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.