In this week’s bulletin:
- Markets still expect a last-minute deal to end the US debt impasse.
- China warns that the stand-off threatens its US investments.
- The White House nominates Janet Yellen as the new head of the Federal Reserve.
- Equities last week steadied on signs of progress on Capitol Hill.
Hope and history
History is not a guide to future performance, but that rarely stops financial markets and investors from glancing back in the hope of gleaning what might lie ahead. And so, with battle lines on Capitol Hill between President Barack Obama and the Republicans drawn but showing signs of compromise over extending the US debt deadline, taking the long view offers some perspective on how a political showdown might affect the global markets. In the meantime, Congress has until midnight on Thursday to approve new borrowing limits, otherwise America will be days away from running out of funds.
Monday 14 October 2013
With the world’s largest economy in the surreal situation of an extensive government shutdown and a looming politically induced financial crisis, markets are expecting a last-minute resolution to extend the $16.7 trillion debt ceiling and for normality to return to Washington. The prevalent view is that the alternative is unthinkable, which is the financial market equivalent of a prayer of faith. Fund manager Invesco Perpetual’s chief economist John Greenwood said either side pushing US into default was “inconceivable”. Despite the deep polarisation over the funding and implementation of the Obamacare programme, markets expect US politicians not to jeopardise the economy. After weekend talks between the White House and Republicans in the House of Representatives broke down, the negotiations have shifted to the Senate, where Harry Reid and Mitch McConnell, the Democratic and Republican leaders respectively, have taken over the bargaining.
Obama has accused the Republicans of holding America to ransom and threatening “economic chaos”. In the absence of an agreement between the Obama administration and the Republicans and their Tea Party faction, the US is expected to be able to fund its interest payments until the end of October. But the failure of Obama’s government to honour its debt obligations would threaten the dollar’s status as the world’s reserve currency, forcing interest rates in the US to rise. All of this would be a very unwelcome outcome for a recovering global economy and buoyant financial markets.
The hope is that history will repeat itself, and the Republicans will strike a last-minute bargain with the Obama administration, as they did in 2011, before the US Treasury’s authority to borrow expires on 17 October. Obama on Friday rejected house speaker John Boehner’s offer to postpone a potential US default to 22 November. Markets the day before responded optimistically to the development, with the S&P 500 recording its biggest one-day gain since the first week of January. If an extension is reached this week, Obama and his opponents will still need to agree deficit reduction measures and to raise the debt ceiling into 2014.
America is not alone in hoping that this latest battle over US fiscal policy will be resolved in time for the Thursday deadline. The International Monetary Fund (IMF) warned that a default would risk severe market instability, and at the weekend its managing director Christine Lagarde warned that US politicians were risking the global economy “tipping, yet again, into recession”. World Bank president Jim Yong Kim said failure would threaten the developing world as well as developed economies. Half of the US debt is held by foreign governments, central banks and overseas investors, and a default would risk those holdings. Foreign investors during the 2011 scare shunned Treasury auctions for about three months.
The US’s main creditors China and Japan also called on Washington to resolve its differences for the sake of the global economy. Beijing warned that the impasse threatened the value of its US investments. China is the largest holder of US Treasuries with $1.3 trillion in July, followed by Japan’s $1.1 trillion. At the time of writing, it was still uncertain whether there was enough support in Congress to raise the debt ceiling. But the world still needs the pull of America’s economic engine to move it clear of the last global recession. There are other specific threats posed by the impasse. The lack of key economic data threatens confidence and growth. The Fed, faced with tighter fiscal conditions, could opt for another round of QE to protect the US economic recovery. Markets could factor in a further delay to the expected announcement of the tapering of the US $85 billion-a-month asset-buying scheme and move towards safer government bonds and away from US stocks.
The impasse in Washington overshadowed the White House’s confirmation last week that it had nominated Janet Yellen, the Fed’s vice chair, to lead the US central bank when Ben Bernanke departs from the position at the end of January. Yellen is considered a monetary policy ‘dove’, and expected to prolong the US quantitative easing (QE) programme. But she will still face the challenge of how to reduce the bond purchases without jeopardising the US economic recovery. The US crisis also eclipsed the IMF’s latest forecasts that took 0.3% off the world’s growth rate for 2013 to 2.9%. The IMF urged the Fed not to taper the QE programme too quickly, warning that a subsequent rise in borrowing costs would hinder growth. However, its forecast reflected the growing optimism that the US recovery is strengthening and it expects the growth rate to accelerate to 2.6% in 2014 from 1.6% this year.
Eye of the storm
Global markets expect common sense to prevail in Washington, and US equities last week steadied on late signs of progress in the negotiations and the selection of Yellen. The S&P 500 last Monday opened for trading with retailers and banks losing previous momentum. However, considering the potential enormity of the US crisis, markets remained sanguine over the following week about the threat of a default, which is considered so beyond the pale it cannot occur. At its lowest point last week on Wednesday the S&P 500 index was 3.4% off from its 19 September historic peak of 1,730 points. In the context of recent history that is a bumpy ride rather than a crash. The sell-off in May and June took 7.5% off the index; while in August there was a 4.8% correction. The US equity index ended the week up 0.12% to 1,703 on the news of talks in Washington.
Market uncertainty in this climate is understandable. Global fund manager Mark Tinker of AXA Framlington noted that equity markets have had a rough start to the month, confronting the “now familiar autumn ‘wall of worry’ generated by politicians and policy makers”. Tinker said that he is expecting a bounce back for equities, particularly if a temporary resolution is achieved on the debt ceiling. Although the CBOE Volatility Index, which measures the level of anxiety on Wall Street, rose above 21 on Wednesday, it fell below 16 on Friday – and remains below the peaks reached in the debt-ceiling crisis of 2011. The impasse has also pushed yields on short-term US Treasuries to their highest level since 2008; although fixed-income volatility measures have fallen, indicating investor confidence in a positive outcome from the negotiations. The ten-year yield closed at 2.68% on Friday, up 3 basis points over the week.
US political problems put downward pressure on equities in other financial centres, although this had the air of a temporary dip. In Britain, the Royal Mail’s launch on the London Stock Exchange spurred a flurry of investor activity last week. Meanwhile, the IMF’s recognition of improved growth in the UK gave further impetus to talk of a housing recovery, as well as the coalition government’s argument that its austerity programme is working. The FTSE 100 index rallied off a three-month low to end the week up 0.52% to 6,487 points.
European equities also reflected the uncertainty earlier in the week followed by optimism for a resolution to the US fiscal crisis. The FTSEurofirst 300 index rose from a one-month low mid-week to settle the five-day period up 0.57% to 1,251. The Nikkei 225 gained 1.5% on Friday and 2.7% over the week to end the period up to 14,405 as Japanese business confidence continues to strengthen.
Politicians and central bankers are exerting an unprecedented influence on global financial markets, as we have consistently noted this year. The two best days for the S&P 500 this year have followed political developments over US fiscal policy. The US equity index rose 2.5% on 2 January after Congress agreed a compromise over the then-looming fiscal cliff; and last Thursday it rose 2.2% on the news that Republicans might offer Obama a temporary stay. In an era awash with easy government money, investors are more beholden than usual to elected representatives, and market volatility is the price of these conditions.
Markets are betting on their hope that politicians will pursue pragmatic compromise rather than battles of principle that could upend the financial system they purport to protect. The probable outcome remains a short-term compromise followed by a deal on the debt. The S&P 500 remains on a roll and is 19% up over the last year. Invesco’s head of US equities Simon Laing noted that the “political pantomime” around the debt ceiling might bring a slight dip in confidence, but the real focus should remain on global economic indicators.
If investors thought that there was going to be a default, there would have been a sell-off. “The US debt crisis is not exercising the markets because the general belief is that the default won’t happen,” said AXA Framlington fund manager George Luckraft. The strength of the US equity market, reflecting corporate confidence and the health of earnings, cash flow and balance sheets, is shining through the political morass on Capitol Hill.
Investors and fund managers are sanguine about the risk of a US default, but there remains no recent historical precedent for a debt default. The US has experienced 18 government closures over the years without major market repercussions, with most lasting only a few days, followed by gains for US equities after government reopened. But the US last defaulted on its debt in 1790, when the newly independent republic deferred until 1801 interest obligations it assumed from the founding states.
US fund manager Aristotle’s principal James Henderson believes that the economic impact of the shutdown will be short-lived. “If history is any guide, we believe any economic headwind caused by the shutdown can be made up very quickly when the government reopens.” But a failure to extend the debt-ceiling deadline remains an unknown. “You’re trying to guess what a small number of people will do,” says Russ Koesterich, chief investment strategist at fund manager BlackRock. “The truth is, we don’t know; it’s never happened. No one expects it to happen; this is not discounted into the market.”
What investors and fund managers can know for sure is that failure by the US to pay its government debt would be unprecedented in modern history – and would be a highly unwelcome development five years on from the devastation the collapse of Lehman Brothers wreaked on the world economy. Put in perspective the $12 trillion of outstanding government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy in 2008. Mohamed El-Erian, chief executive of fund manager PIMCO, noted that the implications of default would be worse than the Lehman Brothers collapse and would devastate markets.
The failure would certainly cause problems for equities and fixed-income assets, borrowing costs and the dollar. El-Erian said that this would add to the headwinds facing economic growth, transmit the default to other economies and undermine the role of America in the world economy. US investment veteran Warren Buffett called on politicians to stop using the debt limit as a policy debate. “It should be like nuclear bombs, basically too horrible to use,” Buffett said.
The bare facts are that the US Treasury will have only $30 billion of cash left by 17 October to meet its commitments of up to $60 billion a day, according to Bloomberg data. Goldman Sachs expects the Treasury’s cash balance to be depleted by 31 October or sooner. The Treasury has $120 billion of short-term bonds due on 17 October, with a further $93 billion on 24 October. But $150 billion needs to be paid by 31 October, including two-year and five-year notes that mature. The total due from 17 October to 7 November is $417 billion. “Nobody knows what would happen if there were a default,” said Koesterich. “Everyone’s flying blind.”