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GOP hawks are threatening to lay siege to the defense budget. Wall Street doesn’t know what to make of it.

“We've gotten questions about it from people who normally don't ask about this kind of stuff,” Alec Phillips, chief political economist at Goldman Sachs, told MM on Monday evening, referring to demands by some Republicans for spending reductions that could chop as much as 10 percent from the Pentagon budget. “I’m a little skeptical that a cut that large would actually get pushed through.”

A potential reduction in defense spending could cast a pall on an industry that had become a haven for investors seeking a reprieve from geopolitical threats and a possible recession.

“We are in a secular shift from benign globalization to great power competition.” said Vance Serchuk, the executive director of private equity firm KKR’s Global Institute, “That transition to great power competition will impose new complexities and requirements for capital providers to navigate.” (KKR owns a major stake in Axel Springer SE, the parent company of POLITICO.)

Washington has done everything possible to support that investment thesis. Back-to-back defense spending bills signed by President Joe Biden authorized huge boosts to the Pentagon, and many financiers — including JPMorgan Chase CEO Jamie Dimon — have been cheering for Congress to double down because of the war in Ukraine and looming tensions with China. More money for the military means more money for aerospace and defense businesses.

Newly anointed speaker Kevin McCarthy’s (R-Calif.) deal with conservatives to cap discretionary spending at fiscal 2022 levels — which would wipe out the $75 billion defense increase enacted last month — could complicate that. While the deal doesn’t include any specifics on what that means for the national security spending, fiscal hardliners like Rep. Jim Jordan (R-Ohio) say that defense cuts could be on the table as lawmakers embark on painful negotiations over the federal debt limit.

Share prices of major defense contractors like Lockheed Martin and Northrop Grumman sank over the last several days as investors “wait to see what Congress does and see how this debate plays out,” Dan Clifton, who heads Washington research at the institutional brokerage Strategas, told MM.

“Most people know that the defense cuts are not the base case, but there is a clear risk aversion from investors since these headlines crossed the wires midday Friday,” he said.

The potential threat comes with plenty of caveats. As our Connor O’Brien reports, many Republicans – including the conservatives who extracted some of McCarthy’s most painful concessions — “have sought to quash chatter of Pentagon cuts, noting they could instead look to make reductions from the non-military side of the ledger.”

The Pentagon has plenty of allies on both sides of the aisle, as well as in the Senate, who will put up a fight if conservatives attempt to slash their programs in the coming battle over the debt ceiling.

“The narrative about defense spending being cut back is a bit overblown, since President Biden and the Democratic Senate (not to mention, many House Republicans) are not going to support significant cuts to defense spending, especially in the particular geopolitical context,” said Libby Cantrill, a managing director in PIMCO's portfolio management group who’s in charge of assessing political and policy risks.

Another key caveat?: “The worst case scenario is that defense spending is flat to 2023, although keep in mind that 2023 defense spending represented an increase in spending of 10 percent on a nominal basis relative to 2022,” Cantrill added. “Even under that scenario, spending would continue to be up for the Pentagon relative to previous years.”

IT’S TUESDAY — And your MM host is still trying to figure out what he thought of “Babylon.” Please send tips to [email protected] and [email protected].

Fed Chair Jerome Powell speaks at the Sveriges Riksbank International Symposium on Central Bank Independence at 9 a.m. … Treasury Secretary Janet Yellen will meet with Canada’s Deputy Prime Minister and Finance Minister Chrystia Freeland at 1:30 p.m.

SPEAKING OF THE DEBT CEILING — Former President Donald Trump took to his social network Truth Social to urge Republicans to play “tough” in the debt ceiling battle.

BLEAK — Community bankers aren’t just bracing for a recession, they think it’s already here. The Community Bank Sentiment Index, which will be released later today by the Conference of State Bank Supervisors, found that 96 percent of community bankers surveyed believe the U.S. is already in a recession. The index, which the St. Louis Fed includes in its trove of economic data, reflects a grim outlook for the U.S. economy as the Fed weighs bumping up rates again in advance of its Jan. 31-Feb. 1 meetings. The bankers also expressed concerns about regulatory burdens, a challenging labor market and threats from cyberattacks.

“The year 2022 was really the worst overall for our index” as a reflection of bankers’ economic outlook, CSBS Chief Economist Tom Siems told MM. “I do think the soft landing is possible but there are concerns on the horizon that show up, not only in the CBSI, but also some of the other indicators.”

— Despite what MM wrote yesterday, it appears as though consumers aren’t feeling nearly as glum, according to the New York Fed’s monthly survey. Inflation expectations are plummeting and the median consumer now expects their household incomes to grow by about 4.6 percent next year — that’s an all time high. Meanwhile, people are still spending at a healthy clip as well. The Fed’s monthly credit report found that consumers added $28 billion to their balances in November, surpassing most estimates.

EVERYTHING IS RENT — Our Katy O’Donnell: “More than four dozen Democratic lawmakers on Monday urged the White House to issue an executive action to protect tenants from further rent hikes following two years of eye-popping increases. ‘People are struggling to pay the rent today, and we must pursue all options on the table that will help renters stay housed in the short-term, while also continuing to collaborate on efforts to realize long-term investments in our nation’s affordable housing supply,’ the lawmakers wrote to President Joe Biden, in a letter spearheaded by Rep. Jamaal Bowman of New York and Sen. Elizabeth Warren of Massachusetts.”

APPEARANCES — Our Victoria Guida stopped by the Macro Musings podcast to give her thoughts on all things Federal Reserve, including the discourse over master account access and new personnel. Also be sure to check out Ben White, Zachary Warmbrodt, Doug Palmer and Garrett Downs break down what to expect from the new Congress.

FIRST LOOK IN MM —The Equable Institute, a bipartisan nonprofit focused on retirement sustainability, gave MM an early look at year-end data showing that the funded ratios of U.S. public pension systems dropped from 83.9 percent in 2021 to 77.3 percent in 2022 as the market downturn hammered investment portfolios.

— ICYMI from over the holidays: “State pension plans were hammered in 2022. Next year will be worse.”

ALSO FIRST IN MM — Americans for Financial Reform is urging regulators to address the looming wall of subprime debt amassed by businesses over the last decade. Rising rates, along with declining markets, “companies saddled with debt from frothier times will find the going tougher than it ever needed to be due to abuses in this sector,” said Andrew Park, senior policy analyst at the progressive think tank. “We need to get ahead of the problem by revamping our outdated rules and laws governing this type of debt and the funds that often issue it.”

SIGNS OF LIFE IN M&A — Bloomberg’s Michelle F Davis, Dinesh Nair, and Gillian Tan: “CVS Health Corp. is exploring an acquisition of Oak Street Health Inc., which runs primary care centers for Medicare recipients, according to people familiar with the matter. The potential deal would value Oak Street at more than $10 billion, including debt, said the people.”

SHOUT OUT TO THE FELLAS — Bloomberg’s Michael Sasso: “Young American men and men with college degrees led the ‘quiet quitting’ movement in the US, according to new research that sheds more light on the pandemic-induced phenomenon.”

HERE WE GO — Reuters’ Saeed Azhar and Scott Murdoch: “Goldman Sachs Group (GS.N) will start cutting thousands of jobs across the firm from Wednesday, two sources familiar with the move said, as it prepares for a tough economic environment.”

THEY WEREN’T LOVIN’ IT —Our Declan Harty: “The SEC has charged former McDonald's CEO Steve Easterbrook with misleading investors about his 2019 firing from the fast-food giant. Following revelations about an inappropriate relationship between Easterbrook and an employee that violated corporate policy, McDonald's fired him and launched an internal investigation during which Easterbrook failed to disclose additional relationships with other McDonald's employees, the SEC alleged.”

THERE’S ALWAYS A HOUSING ANGLE — WSJ’s Salvador Rodriguez: “Meta Platforms Inc. said Monday that it has begun implementing technology designed to improve the equity of housing advertising displayed to Facebook users as part of a June settlement agreement with federal officials.”

THE FUTURE IS CRYPTO AI — Bloomberg’s Hannah Miller: “Crypto startups are facing a harrowing time attracting private financiers after the collapse of digital-asset exchange FTX. Venture capital investment in the industry plunged to its lowest level in almost two years during the fourth quarter of 2022, according to data from research firm PitchBook.”

I’M OUT — Metropolitan Commercial Bank is getting out of the crypto business. After its dealings with the bankrupt crypto broker Voyager Digital attracted FDIC scrutiny – the bank regulator blasted Voyager over its characterization that its customer deposits were FDIC insured — the New York-based bank has “commenced the process of closing out its relationships” with crypto clients that represented 1.5 percent of total revenues and 6 percent of its deposits.

PRIVACY IN A CRACKDOWN — As Congress weighs a crackdown on crypto startups, a coalition of industry associations, startups and civil liberties groups led by Fight for the Future are urging lawmakers to emphasize “take a bold stance for a pro-privacy” regulatory regime, according to a letter shared with MM.

Former Rep. Maxine Waters (D-Calif.) chief of staff Clement Abonyi has joined the Credit Union National Association as its Director of Advocacy.

Megan Hannigan is now legislative director for Rep. Gregory Meeks (D-N.Y.), handling his financial services portfolio. She previously was lead Democrat on PayPal’s federal government relations team. — Daniel Lippman

Joe Biden condemned violent riots in Brazil as the White House faced calls from Congress to expel Jair Bolsonaro, the Latin American country’s former president, from the US, where he has been staying since leaving office. — FT’s Felicia Schwartz, Stefania Palma and Bryan Harris

People across the eurozone may receive substantial pay increases over the coming quarters, the European Central Bank said today, pointing to a trend that will likely cement its commitment to raising interest rates substantially. — Our Johanna Treeck