This article was featured in the Georgia Association of Public Pension Trustees’ newsletter.
This spring, UNC Wilmington’s Cameron School of Business celebrated its 41st Annual Business Week. This three-day event brings together industry and community leaders, alumni, and students for conversations on numerous local, national, and global topics.
At the forefront of conversations this year were questions surrounding policy: the debt ceiling in the U.S., regional bank stress, and ongoing geopolitical conflict. John Fagan, co-Founder of Markets Policy Partners, a D.C.-based financial markets and policy advisory service, touched on these topics during one of the conference’s keynote speeches.
Before founding Markets Policy Partners, John was Director of the Markets Analysis Group at the U.S. Department of the Treasury. This group provides real-time analysis of global financial markets to senior Treasury Department and White House officials. John served in this role across two administrations from 2014 until 2018. In recognition of his service in this role, John was awarded the Secretary of the Treasury's Merit Service Award in 2018.
After the conference, I caught up with John to expand on some of the main topics discussed in his keynote address. With his background interpreting financial markets and providing guidance on market ramifications of policy initiatives, I believe John provides a unique lens into current market events. I hope you find his insights interesting food for thought. 
Matt Raines: John, you sat at the intersection of global financial markets and public policy in your role at the U.S. Treasury. Right now, a lot of attention is focused on the U.S. debt ceiling. How do you think about the implications of the U.S. debt negotiations from a market practitioner’s standpoint? What implications are there for financial markets?
John Fagan: The first point I would make is that low probability / high impact risks (I would categorize the debt ceiling issue as such) are generally very difficult to account for in your investment portfolio. This is particularly true when the risk is centered around policy, since we all know policymaking is akin to sausage-making, with lots of uncertainty around outcomes and timelines given the highly politicized negotiating environment.
In this case, however, investors may feel that they have seen this movie before and may be prone to succumbing to a false sense of security when they assume that an 11th-hour deal will materialize just like it has in each of the past debt ceiling showdowns. I think this time is different, in that the brinksmanship will be more daring and the political environment is that much more toxic. Still, I have heard from clients that they are distinctly unwilling to completely restructure their investment strategy around the risk of a U.S. debt default. This stands to reason, but the lack of a headline-grabbing equity market reaction to the debt ceiling issue does not help focus the minds of the two sides in Congress.
So while broader markets are, thus far, content to largely ignore this issue, where I do see the market impact of debt ceiling concerns is in the distortion of the T-bills curve and the historically elevated U.S. credit default swap spread, which is essentially the cost of insuring against a U.S. sovereign default. These price dynamics align with my view that this episode of the debt ceiling fight brings a much higher risk of accident. While I think that a debt ceiling accident is still unlikely, the odds are uncomfortably high. The market reaction is uncertain, beyond the general consensus expectation of a major equity sell off. For example, when S&P downgraded the United states credit rating in 2011 following what was previously the most dramatic debt ceiling game of chicken, Treasuries and the dollar (somewhat counterintuitively) rallied because, regardless of the downgrade, investors still viewed these as the safest haven assets. I expect a similar dynamic would play out, but likely even more extreme.
My base case is that we get an extension ahead of the June 1st x-date (the potential government default date) given the very short time frame for deal making and, importantly, the congressional recess for Memorial Day weekend that immediately precedes the June 1st deadline. Following that, I expect that the Senate will eventually produce a budget bill that is acceptable to a large enough number of House Republicans and even some moderate Democrats to get the deal done. Speaker McCarthy is in a stronger position than most people had expected by this point. It seems as through a compromise deal, even if he loses a meaningful chunk of his caucus, that he will be able to retain his speakership.
MR: The level of geopolitical risks seems to be at an all-time high with the conflict in Ukraine, heightened tensions with China, and building conflict in Sudan. How do you think about these issues through the lens of financial markets?
JF: First of all, I will say that geopolitical risks tend to be less well understood among the Wall Street crowd than many other classifications of risk. You certainly have your armchair generals, but overall the understanding of geopolitics, at least in my experience, among financial industry participants is relatively modest. Part of the reason for a lack of analytical resources being thrown at geopolitics is that trading geopolitics tends to be a very hard way to make money. This is partly because catalyzing events are unpredictable, often on purpose, and also because many of the central geopolitical themes play out on longer arcs of history that bend beyond the investible time horizon.
My view, since the inception of Markets Policy Partners in 2018, has been that geopolitics is very much back as a key driver of markets, and the examples you cite bear this out. The Russian invasion of Ukraine had first-order effects on Ukraine and Russian assets and secondary impacts on wheat, oil, and other commodities that are somehow implicated in the conflict by virtue of the antagonists producing various combinations of those commodities. The nagging risk of escalation and expansion of the war has faded somewhat but could certainly come back to the fore and spread generalized risk aversion across global markets.
As for U.S.-China, my view remains that structural realignment of U.S. policy toward China is an organizing principle for macro investors to orient their investment strategies around. It has strong bipartisan support and is firmly driven by the national security establishment.
MR: It wouldn’t be an appropriate financial interview if I did not ask about the Federal Reserve. Markets are pricing in cuts later this year, while the Fed is projecting no cuts. Are markets wrong? What do they see that the Fed doesn’t?
JF: I agree that this divergence between Fed guidance on rates and futures markets pricing of rate cuts starting as early as September is not only glaring but has persisted in the face of rather strenuous messaging by the Fed that no rate cuts are anticipated before year-end. The reconvergence between where the market is on rates and where the Fed is, one way or the other, will be a critical macro dynamic in the second half of this year and into 2024.
It is always a little uncomfortable saying I think the market is wrong, because markets have tended to know what the Fed is going to do before it does – but in this case, I think the market is offside in regards to interest rate cuts later this year. A September cut would be a neck-snapping policy pirouette even for Fed Chair Powell, who has been prone to prompt policy pivots during his tenure.
MR: There has seemed to be a disconnect in markets this year with a sizable counter-trend rally in growth stocks while the bond markets have continued to give signals of the likelihood of a recession. How would you describe the price action we have seen in both equity and bond markets to date and how could they potentially be impacted by Federal Reserve action and rhetoric later in the year?
JF: First off, disagreement between the equity market and bond market is, as you know, quite common. Conventional wisdom generally gives the nod to the bond market on being the one that is generally correct when there is a disconnect, with the stock market often being late to realize that it is offside on a macro call. I think the bond market will be right again this time, at least about the prospects of a recession if not about the Fed policy outlook.
For now, I think the rebound in growth stocks is being animated by two interrelated factors on the macro side –anticipation of Fed rate cuts and expectations for a generally soft growth picture over the coming quarters and into 2024.
A lower interest rate environment hast ended to favor growth stocks, with their earnings profile more biased toward the future, allowing a lower discount rate to flatter this segment of the market. Relatedly, a subdued or stagnant economic environment that affords low-interest rates is also relatively beneficial for growth stocks, as investors will pay a premium for the organic/endogenous growth prospects that those companies offer.
Unfortunately, I expect growth to slow into mildly recessionary conditions through the back half of this year, but I do not expect the Fed to be cutting rates anywhere close to the extent that the markets are anticipating.
Will growth stocks be able to outperform in a low growth / elevated interest rate environment? That is possible over the medium term, but I would expect the initial reaction to the combination of clearly deteriorating growth and a stubbornly on-hold Fed (which should become clear over the summer) to be challenging to all equities and the higher beta growth stocks will probably suffer disproportionately in the early stages of this realization.
MR: We have seen a swath of regional banks collapse in the first half of this year, first with Silicon Valley Bank and most recently with First Republic. The question is whether this is truly contained, or will there be further contagion? With your Treasury Department policy hat on, how would you think this potentially impacts the banking sector moving forward with increased regulation etc.
JF: Though I have expected policymakers to successfully address the most acute problems in the banking system, eventually break the systemically pro cyclical price action in financial sector assets, and ease panicky depositor behavior, the lasting impact on sentiment and financial conditions will remain a source of medium-term volatility in markets and downside risk for the economy.
In short, I think the regional banking issue becomes a chronic condition, with headline risk and a lengthy timeline since the core issue is low-yielding long-term assets on their balance sheets and higher deposit costs. So while the Fed and Treasury can maintain programs to make sure these banks have the liquidity they need, there is nothing they can do about their profitability.
MR: With recent stress in the regional banking sector, a lot of people and attention has turned to the commercial real estate market and potential issues there. What are your views on potential stresses in that sector?
JF: The fact that the recent string of regional bank failures is not about deterioration in the loan book, but about confidence of depositors and duration risk management failures in reserves, suggests that there is more stress ahead as the economy slows.
Losses in the commercial real estate space and in the rest of the loan book have yet to be realized, and will worsen if I am correct and the U.S. economy enters a recession later this year while the Fed remains very hesitant to supply timely easing in the face of sticky inflation.
Obviously, investors are trying to price in these impacts, but I am concerned that the risk of reflexive reactions around earnings or other disclosures by regional banks will remain high over the coming quarters. There will be large losses in the non-prime locations as leases slowly roll off and businesses shrink their footprints in the new post-Covid world. However, the reality is that this will be a bigger issue than just regional banks, as pension funds and life insurance companies are the largest investors in CRE.
 Please note: The opinions expressed are solely that of the interviewee and do not necessarily reflect the views of Balentine.