Funding Fault: Recurring US Debt Dilemma Takes Toll
Part 3: Keep Calm and Carry On
This third post of the three-part series about the ongoing US debt ceiling debate offers strategies to help investors position themselves for the next debt showdown in January 2014. Part 1 examined circumstances surrounding the latest deadlock last September, while Part 2 discussed the relatively minimal reaction to the debt dilemma in the markets.
How should investors prepare as the debt debate encore plays out in early 2014? Just as a British World War II poster advises: “Keep calm and carry on.” These four snapshots of broader long-term market and economic trends provide useful context for dispassionate evaluation of shorter-term current events.
1. Economy: A loaded freight train
Over the 12-month period ending Sept. 30, 2013, the US economy produced $16.9 trillion in goods and services, 3.1% higher than a year earlier in nominal terms.1 Challenges notwithstanding, the economy is like a loaded freight train — unlikely to set speed records, but moving at a steady pace with massive momentum behind it.
A positive sign is that the government’s share of the economy as a percentage of gross domestic product has decreased— from approximately 25% in 2010 and 2011 to roughly 23% currently2 — which means the private sector’s contribution is increasing.
2. The Fed: A new head
On Jan. 31, 2014, Janet Yellen will replace Ben Bernanke as chairman of the Board of Governors of the Federal Reserve (Fed). She is viewed as an inflation dove who will likely support continued monetary accommodation if forced to choose between addressing inflation or lingering unemployment.
The Fed’s ongoing policy of asset purchases, known as quantitative easing (QE), has boosted its balance sheet to nearly $4 trillion, an increase of more than 300% since it initiated QE in 2008.3 Additionally, the Fed will continue its policy of keeping its short-term interest rate near zero as long as the unemployment rate remains above 6.5%. All else equal, accommodative Fed policy stimulates the economy and is generally supportive of stocks.
3. Equity market: New highs
A growing private sector should generally be positive for the stock market. As the chart below shows, the S&P 500 Index was up 28% year to date through the middle of November as it continued to reach new highs that have underlying fundamental support.
New Highs for the S&P 500 Index Supported by Fundamentals
Source: Bloomberg L.P., Nov. 18, 2013
With both the stock market and Fed balance sheet at all-time highs, what should investors expect if the Fed begins tapering?
- Keep in mind that tapering is more like lifting a foot off the gas than slamming on the breaks. A car that slows from 85 to 75 miles per hour is still moving fast.
- Probably more important, the banking system has used the money from Fed asset purchases to build excess reserves rather than lending it. If this additional money isn’t flowing into the stock market or economy, slowing the flow with tapering may have little discernible impact on the stock market.
4. Inflation: Likely to remain low
Despite significant growth in the monetary base, inflation and inflation expectations remain in check. For the 12 months ended Oct. 31, 2013, the Consumer Price Index was up just 1.2%, with five-year inflation expectations at 1.8%.4 The unwillingness of banks to release their excess reserves into the economy via additional lending is contributing to these low levels. With bank lending only just recently recovering to its 2008 peak, in an economy that’s 16% larger,5 any upward pressure on the velocity of money — and by extension, inflation — will likely remain low.
Stay the course
Early 2014 may take us back to the future. While investors shouldn’t turn a blind eye to challenges facing the economy and markets, looking at the broader picture can help them stay the course and keep moving forward with their financial goals.
1 Source: Bloomberg L.P., Sept. 30, 2013
2 Source: Federal Reserve Bank of St. Louis, Sept. 30, 2013
3 Source: Bloomberg L.P., Nov. 18, 2013
4 Source: Bloomberg L.P., Oct. 31, 2013
5 Source: Bloomberg L.P., Federal Reserve Bank of St. Louis, Oct. 31, 2013
The S&P 500® Index is an unmanaged index considered representative of the US stock market. An investment cannot be made directly in an index.