(MENAFN- Khaleej Times) On the surface, the stock market has been remarkably calm. Despite occasional declines, the S&P 500 has returned roughly 8 per cent over the past year, including dividends. If that solid performance were the only information you had about the state of the markets, it might lead you to believe that there was nothing much to worry about.
But you would be wrong. The relatively calm markets of recent weeks are extraordinary, considering what lurks beneath them. Invest in the markets, certainly, but hedge your bets. The peaceful mood could sour quickly.
Just for a start, the debt ceiling crisis is still unfolding. If an agreement isn't reached in Washington before early June, the United States could run out of money to pay all of its bills. This has never happened before, so we don't really know how bad it would be, but it's safe to say that it would range somewhere between awful and catastrophic.
Social Security checks might not be issued, government employees might not be paid and the United States could even default on its debt.
For decades, US Treasurys have been viewed as the safest of assets, the foundation of the entire global financial system. The odds of a default are low but significant - somewhere from 3.5 to 4.3 per cent, according to calculations by the financial services company MSCI that are based on pricing for insurance in the credit default swaps market. The consequences of a default could be dire. Numerous erudite studies have been done, trying to handicap the possible outcomes. In a sign that fixed-income specialists are deeply worried, the yield on Treasury bills that mature on June 1 soared to 7 per cent, approaching junk bond territory.
A protracted default could devastate the US economy, as well as the global one, and result in higher long-term borrowing costs for the US government and a geopolitical shift away from the primacy of Treasurys and the dollar.
I think politicians are likely to find it to their advantage to raise the debt ceiling before the damage goes quite that far, but even a“Perils of Pauline” end to this crisis, with a last-minute rescue from a default, could easily set off a panic in the stock market.
What's more, an ugly but not cataclysmic end to this impasse could lead to further downgrading of US debt, which lost its pristine Triple-A rating from Standard & Poor's as a result of a close call, but no default, in 2011. Periodic bouts of political dysfunction - putting the United States in danger of becoming a global deadbeat, despite its many economic advantages - aren't helping the US economy. The only question, really, is how bad all of this will be.
But even if this crisis is resolved without much disruption and most markets continue to treat the debt dispute as a minor problem, the markets and the economy will not be out of the woods.
“Once the debt crisis is behind us, the focus of attention is likely to shift back to the Federal Reserve,” Daleep Singh, chief global economist for PGIM Fixed Income, said in an interview. The Fed has been raising interest rates since March 2022 in its battle with inflation and needs to decide what to do at its next meeting in June.
“The Fed faces a trifecta of risks,” he said. They are:
- The potential for economic drag from the more restrictive fiscal policy that House Republicans are demanding from President Joe Biden as a prerequisite for an increase in the debt ceiling.
- The lagged effects of the Fed's restrictive monetary policy. Is a recession on the way? Is inflation vanquished? Should the Fed raise rates further, hold them where they are or begin to cut them to avoid a downturn?
- The possibility of renewed flare-ups in the banking system. Regional banks like Silicon Valley Bank and Signature Bank have been rescued by regulators, First Republic was acquired by JPMorgan Chase, and banks including PacWest, Western Alliance, Comerica and Zions Bancorp have come under pressure. Bank runs and losses on long-term investments, aggravated by the Fed's policy of raising interest rates, could resume if the Fed holds rates at current levels or raises them further.
Oddly, the debt ceiling crisis provided temporary relief for many of the nation's banks, economists for Moody's Investor Service found in a recent study.
“The debt ceiling impasse has been a tail wind for the banks,” Jill Cetina, associate managing director for Moody's, said in an interview.
But once the debt ceiling is lifted and the Treasury begins to raise money by selling large quantities of bonds, those purchases by investors in the open market will drain money from banks.
“This may not be what you would expect, but the resolution of the debt ceiling crisis will be a headwind for banks,” she said.
Global tensions remain high. Russia's war in Ukraine grinds on, at a staggering cost. Russia and China, its supporter if not formal ally, are nuclear powers, and as Nato countries provide increasingly lethal military aid to Ukraine, the threat of a tragic escalation of the conflict can't be entirely dismissed. From a purely economic standpoint, while energy prices have dropped sharply from their peaks at the start of the Ukraine war, the possibility of further unexpected shocks remains. US-Chinese relations are fraught, and global trade relationships have been fraying.
On top of that, while the emergency phase of the pandemic has ended in the United States and many other countries, the coronavirus is still with us, and it continues to exact a harsh toll in death and suffering. From May 4-10 alone, 840 people died of Covid-19 in the United States, bringing the steadily rising US death count to about 1.13 million. Scores of thousands of people suffer from the disease's long-term effects.
In an economic sense, the effects of Covid-19 are still with us, too. The expansive fiscal and monetary policies enacted to combat the recession induced by Covid in 2020 were strikingly successful in restoring economic growth. But the bout of inflation that has spread through global economies in the past two years also stems partly from those policies and the supply shocks engendered by the virus. Even if the coronavirus does not erupt again in the United States, the economy and the markets are still readjusting, putting the Federal Reserve in a quandary, and countries like China continue to experience serious outbreaks.
So for investors who may have been lulled by the rise of the stock market in the United States, I'd say hang in there - but be careful.
There are too many variables at the moment to be able to predict which way we're heading this year.
What are we facing in the months ahead? Recession? Stagflation? A soft landing? A new tech boom powered by artificial intelligence?
I wish I knew. I'm investing for the long haul anyway, but to do that in a fog of uncertainty, it's best to diversify. Hold stocks and bonds from the entire world through broad low-cost index funds.
Yes, I'm pleased that the stock market rebounded this year, but I'm preparing for all eventualities.
This article originally appeared in The New York Times.