Move Along, Market: It’s Only a Gaper’s Delay
After several days of stalemate between the White House and Congress, House Republicans have offered a six-week debt ceiling extension conditional on negotiating a package of fiscal concessions. The debt ceiling offer is straightforward, but the shutdown would continue until the fiscal concessions are agreed on. While this may dampen the economy and equity market, at least in the short run, I believe long-term investors should stay put and be patient.
Fix the debt ceiling first
The shutdown has implications for many sectors of the economy, not just for the 800,000 federal workers going without pay. By one estimate, every week of government shutdown shaves approximately 15 basis points off the gross domestic product (GDP) growth annualized rate.1 Surveys show that 58% of private contractors say the shutdown will dampen their business activity.2 Federal Housing Administration-insured loan borrowers (representing 15% of the housing market) will have their closings delayed.2 We can also expect a slowdown in the initial public offering market after the Securities and Exchange Commission’s (SEC) “carryover” funds are depleted in a few weeks. 2
That said, the debt ceiling is a more pressing concern. Failure to extend the debt ceiling is not an option for two reasons, in my view. First, the government would be required to balance the budget immediately, cutting spending by 20%, which is 4% of GDP.3 Secondly, the country would default on its debt, and its credit rating would be downgraded.
I see three potential outcomes:
- The debt ceiling can be increased under the Second Liberty Bond Act of 1917 that establishes the debt ceiling.
- The Federal Reserve (Fed) could violate the Federal Reserve Act that prohibits the Fed from lending directly to the Treasury.
- The president could invoke the 14th Amendment of the Constitution, which states the debt of the US government, lawfully issued, “shall not be questioned.”
Whatever the outcome, I expect the government to avoid default.
The stock market appears rather optimistic
What do these events mean for stocks? An Oct. 7 report from the quantitative strategists at Instinet states, “Recent price action in the equity market seems to suggest a degree of optimism over the outcome of the current budget and debt limit impasse in Washington.”4 But they also note that a spike in the economic policy uncertainty index indicates the market’s downside risk is twice as large as its upside opportunity.4
The economic policy uncertainty index is important because of its relationship to stocks’ implied long-term earnings growth, a measure of the market’s pricing of future earnings growth. Historically, since 2005, as uncertainty receded, risk aversion fell and implied long-term earnings growth accelerated. 4 But today, a large disconnect exists between implied long-term earnings growth and economic policy uncertainty. 4
Instinet predicts that the S&P 500 Index could fall 15% to 1440 if long-term earnings growth actually falls to the levels suggested by the policy uncertainty index, or it could climb 8% to over 1800 if the impasse is resolved. 4
I would also point out that a recent Bloomberg analysis showed that in past instances of government shutdowns since 1976, the S&P 500 Index rose 11% on average in the 12-month period afterward.5 Keep in mind past performance is no guarantee of future results.
Investors should stay patient
The potential increase in market volatility and potential market decline should be a greater concern to equity traders than investors. Long-term investors may be well served by remaining patient and understanding that the potential short-term volatility and/or market correction related to the debt ceiling debate is likely temporary. I expect the S&P 500 Index to return to its previous levels after the political impasse is broken. I believe the market is currently experiencing a “gaper’s delay,” where everybody slows down to look at an accident but once passed, eventually reaccelerates to their previous speed.
1 Source: Morgan Stanley, Oct. 1, 2013
2 Source: Gluskin Sheff, Oct. 2, 2013
3 Source: Bank of America/Merrill Lynch, Oct. 1, 2013
4 Source: Instinet, LLC, Oct. 7, 2013
5 Source: Bloomberg L.P., Oct. 1, 2013
Basis point is a unit that is equal to one one-hundredth of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. 100 basis points equal 1%.
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.
The economic policy uncertainty index was developed by Scott R. Baker, Nicholas Bloom and Steven J. Davis (“Measuring Economic Policy Uncertainty,” May 19, 2013) to track the movements of policy-related economic uncertainty based on the frequency of newspaper references to policy uncertainty and other indicators.
Past performance is no guarantee of future results.
Prices of equity securities change in response to many factors, including the historical and prospective earnings of the issuer, the value of its assets, general economic conditions, interest rates, investor perceptions and market liquidity.