Market Declines as Debt Limit Ceiling Issue Deadline Approaches

The theme of last week’s column, namely that the markets were on edge as the government shutdown began last week, has continued into the start of the new week as well. The S&P has now declined to its lowest level in a month by going down for 10 out of the past 13 sessions since its all-time high on September 18, for a decline of three percent. That high in both the S&P and the Dow Jones Industrial Average was a function of the Federal Reserve not tapering any of its current stimulus programs currently in effect that involve $85 billion in bond purchases a month.

What transformed that euphoria into the current wave of caution among investors has been the utter inability of the politicians in Washington, D.C. to come to any semblance of agreement over either ending the second week of a government shutdown or more ominously the rapidly approaching deadline of October 17 to increase the nation’s borrowing power or risk a default.

Over the weekend, positions appeared to have hardened as Republican House Speaker Boehner vowed not to raise the U.S. debt ceiling without what he called a “serious conversation” about what is driving the debt. Democrats countered by saying that it was irresponsible and reckless to raise the possibility of a U.S. default.

The last big confrontation over the debt ceiling in August 2011 finally ended with an 11th-hour agreement under pressure from plunging markets and warnings of an economic catastrophe if there was in fact a default. A similar last-minute resolution still remains the best hope at the present time.

Over the weekend, the anxiety resulted in European markets declining to a four-month low while the S&P is now three percent below its all-time high as previously referred to. This was the result of neither political party offering any signs of an impending agreement on either the federal shutdown or the debt ceiling issue, with each side naturally blaming the other for the stalemate.

Speaker Boehner said that he was willing to sit down and have a conversation with the President, but added that Mr. Obama’s “refusal to negotiate is putting our country at risk.” Treasury Secretary Lew warned that Congress is “playing with fire,” and added that the president would not negotiate until “Congress does its job” by getting the federal government up and running again and raising the debt ceiling.

China, the largest holder of U.S. Treasuries at $1.3 trillion, pleaded with Washington to take specific steps to avoid a crisis and ensure the safety of those Chinese investments. Japan is the second largest holder of U.S. debt at $1.1 trillion. A Chinese government spokesman said that he hopes the U.S. “fully understands the lessons of history,” referencing the first-ever downgrade of the U.S. credit rating after the August 2011 crisis. In fact, if such an unthinkable default occurred, those who would get hurt the most would be recipients of Social Security, the Fed which has bought all of that Treasury debt and then China.

What were originally separate issues of the federal government shutdown and the debt ceiling have become intertwined as the October 17 deadline for the latter approaches. The tea party faction of the Republican Party has opposed funding the government for the current fiscal year until they get concessions from the president that would delay or defund the Affordable Care Act. Now they appear to want to place similar conditions in order to raise the debt ceiling, although the Speaker did not appear to go that far as he raised the “spending problem” issue, by which he means entitlement programs such as Social Security and Medicare.

As of now, all three credit ratings agencies have said that the U.S. debt picture has improved greatly over the past two years as a result of G.D.P. growth and a lower trend to the budget deficit. But the Fitch agency is making noises to the effect that the U.S. rating is at risk because the failure to raise the debt ceiling calls into question the full faith and credit of the U.S. to honor its obligations and that political gridlock poses the greatest risk to the outlook. Let it be recalled that it was Standard & Poor’s first-ever downgrade of the U.S. credit rating in August 2011 that caused all of the market turmoil at that time.

While the government is partially shut down, the usual flow of economic reports has been disrupted and the most important one of all, namely the monthly non-farm payroll report issued on the first Friday of the month, was not released. This means that the Federal Reserve will have that much less information upon which to make its next interest rate and tapering decision later this month at its next meeting. Other reports that have already been delayed include August factory orders and construction spending and if there is no solution to the current impasse this week, the next two reports to be put on hold will be September retail sales and the August trade deficit.

In addition to all of the current high-stakes political drama being played out, investors will have to deal with the start of the third-quarter earnings reporting period this week. At the present time, the projection is for earnings gains of slightly under five percent and revenue growth of around two percent. This would be in line with the first and second quarters but the problem could be if companies lower their forward guidance for the fourth quarter due to the uncertainty that the current political turmoil is causing. As of now, the consensus is for earnings growth of close to 10 percent in the final quarter of 2013, and it is easy to see how these potentially large gains could be trimmed back if the current political high-wire act does not get favorably resolved.

A measure over how investor anxiety is building is being reflected in the VIX, or volatility index. Historically the stock market and the VIX move in opposite directions, but at the close of trading this past Monday with the S&P still ahead for the year by 17.5 percent, the VIX was also higher than where it began the year. This is a very unusual occurrence and shows the extent to which what has turned into a major political fiasco in Washington, D.C. has impacted investor thinking.


 

Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.

If you have any questions, contact dselkin@nationalsecurities.com.