Game Theory Offers Clue to Market Calm Amid Debt Impasse

(Bloomberg) — The US is hurtling toward a credit default that pundits universally agree would be catastrophic for the economy and financial markets. So why is the S&P 500 treading water near a nine-month high?

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Game theory offers some insight, according to analysts at Citigroup. Simply put, investors could unload risk assets now and force negotiators into a deal — and then immediately regret that they sold. Holding tight, though, could lead to an impasse that eventually craters the economy and markets.

“Investors shouldn’t be seeking to game the politicians into a solution — that is a risky and uncertain proposition at best,” wrote analysts led by Nathan Sheets. “Rather, with or without an immediate market response, the debt ceiling brings heightened economic and financial uncertainty and other pressures. And investors are well-advised to respond to that reality, as dictated by their investment horizons and appetite for risk.”

The S&P 500, currently hovering just above 4,200, is around its highest level in nine months, propelled, in part, by news that lawmakers were making some progress on debt-ceiling talks in recent days. President Joe Biden will again meet with House Speaker Kevin McCarthy on Monday. Meanwhile, Treasury Secretary Janet Yellen said the US is unlikely to reach mid-June and still be able to pay its bills, underscoring the urgency of reaching a deal.

“The reason that the market has held up is because most people on Wall Street don’t believe Congress is that stupid, and that simply this is another example of Congress teaching Hollywood a thing or two about drama,” said Sam Stovall, chief investment strategist at CFRA. “In the end, they will come to an agreement and I believe that is why the market is remaining fairly resilient — only the most bearish of bears, the most cynical of cynics believe that the extremists in DC want us to go into default.” Stocks could rally after a resolution has been reached, he added.

Read more: Biden-McCarthy Meeting Tees Up Tense Week of Debt-Limit Talks

Since 2011, a meaningful stock-market decline has typically been required to force policymakers to come to an agreement, according to Lori Calvasina, head of US equity strategy at RBC Capital Markets.

Those drawdowns have varied anywhere between 5-6% to 10-19% during what she calls “higher-drama years.” Still, angst around the debt ceiling has given investors a reason to rotate out of growth and into value, helping backstop the S&P 500, she said.

“If Washington does manage to get a deal done, this will likely remove a key downside risk for the stock market and is likely to cause the bears to quiet down,” Calvasina wrote in a note.

Others point out that market gains are capped right now thanks to worries around the debt ceiling. The overhang is putting a lid on the market right now, according to Elyse Ausenbaugh, a global investment strategist at JPMorgan Wealth Management.

“So long as we get a resolution to the debt ceiling — which is our base case — we do think that it’s possible in the near-term you actually see the S&P 500 break above our year-end target of 4,300,” she told Bloomberg TV.

(Updates second graf to include opposite scenario of selling.)

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