Analysis-US debt ceiling deal could stall safety flight fueling megacap rally

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NEW YORK (Reuters) – A potential deal to lift the U.S. debt ceiling could spur money managers to pare holdings in the massive technology and growth stocks that have been havens this year and shift into the rest of the market, some investors believe.

Strong balance sheets and predictable cash flows have made megacap stocks such as Google parent Alphabet (NASDAQ:GOOGL), Microsoft Corp (NASDAQ:MSFT) and Amazon.com (NASDAQ:AMZN) attractive places to hide over the last few months as investors worried about everything from the debt ceiling to a U.S. banking mess.

That has boosted their share price and buoyed market indexes, while leaving other stocks behind.

Megacap tech stocks command heavy weightings in major indexes. Their rally has been responsible for all of the 8.3% year-to-date gain in the S&P 500 through Wednesday’s close, a Deutsche Bank (ETR:DBKGn) report showed. Without them, the index would be down 0.5% for the year otherwise, according to the research. Through Thursday’s close, the index was up 9.3%.

Should a deal on the debt ceiling be reached, “the pattern that we’ve seen over the last few months will reverse,” said Michael O’Rourke, chief market strategist at Jones Trading, who is more bullish on equal-weighted S&P 500 exchange-traded funds than the market-cap weighted index. “The market as a whole is pricing in a lot more risk than those mega-cap names, and going forward a resolution could mean the market broadens out and outperforms that group.”

Investors are watching Washington for signals that the White House will come to an agreement with congressional Republicans to increase the U.S. borrowing limit before the so-called X-date of June 1, which the Treasury Department has said is the day the federal government will run out of money to pay its bills. President Joe Biden and top U.S. congressional Republican Kevin McCarthy both expressed confidence Wednesday that a deal would be reached, avoiding fallout that would be sure to roil financial markets.

Spreads on U.S. government one-year credit default swaps – market-based gauges of the risk of a default – have been declining over the past few days amid signs of progress on debt ceiling discussions, standing at 154 basis points on Thursday, about 20 basis points below last week’s levels, according to S&P Global (NYSE:SPGI) Market Intelligence data.

A recent survey of global fund managers from BofA Global Research showed that 71% believe a deal to raise the debt ceiling will be reached before the X-date.

Randy Frederick, Managing Director of Trading and Derivatives at the Schwab Center for Financial Research, believes a deal would prompt investors to move back into shorter-term U.S. Treasury maturities, which some have been avoiding due to debt ceiling concerns. A deal could also boost shares of companies in sectors that are benefiting from the continued strength in the U.S. economy, such as consumer discretionary, Frederick said.

“Giant mega cap companies that have huge balance sheets have been a nice place to hide,” he said. “We expect to see some movement back into Treasuries because you’re getting a nice yield, and some other parts of the equity market that have lagged behind.”

Of course, investors are unlikely to abandon tech stocks entirely, after a decade during which the category has led markets higher. Excitement over artificial intelligence, which has boosted some megacap names this year, is another factor that could support the category.

Many would also view a broadening of the equity rally as an encouraging sign of the market’s overall health.

“For the market to send a stronger signal substantiating direction, we will need to see … improved breadth/participation,” John Lynch, chief investment officer at Comerica (NYSE:CMA) Wealth Management wrote earlier this week.

At the same time, the debt ceiling has been only one of of several worries weighing on the market. Concerns that the Federal Reserve’s aggressive monetary policy tightening could reduce economic growth, and worries about the recent tumult in the banking sector are likely to remain, even if a default is avoided.

Paul Christopher, head of global market strategy at Wells Fargo (NYSE:WFC) Investment Institute, expects lawmakers will reach an agreement to extend the debt ceiling through September.

Among the sectors he is bullish on is healthcare, a part of the market seen as a haven during troubled economic times.

“It’s been a very tilted market,” he said. “We think investors are going to look through this soon and try to find areas that are going to generate revenue if growth comes down.”