You ain’t seen nothin’ yet.
The cliffhanger of a fiscal cliff deal was just a dress rehearsal for the late-January/early-February battle over raising the debt ceiling.
This one could really move global markets. And move them fast and hard in the not so distant future.
This time it’s worse for three reasons.
- This time the damage from missing the deadline for a deal sets in on Day 1. The negative effects of not reaching a fiscal cliff deal on taxes and spending on January 1 or thereabouts was never going to be immediate. In the fiscal cliff crisis tax rates would indeed have gone up immediately, but tax payments would only have increased gradually and spending cuts would have been phased in over time. The damage to the U.S. economy from a fiscal cliff failure would have indeed been major—perhaps enough to send the U.S. economy back into recession. But the damage would have been only gradually felt by the overall economy. That’s why economists, Wall Street pundits, and politicians kept saying that is was possible to go over the cliff and still fix the problem before the economy suffered any major damage. (The so-called Bungee Cord strategy.) That’s not true with the debt-ceiling crisis. This time the damage is likely to be big and immediate. And some of it won’t be easily reversed.
- This crisis is really three crises in one. Crisis #1–the extension of the debt ceiling—if Congress doesn’t raise the current $16.4 trillion debt ceiling, the U.S. Treasury can’t increase net borrowing to pay the country’s bills. In practice Treasury has ways to manage the country’s debt levels so that it can keep on paying U.S. obligations until, according to estimates from the Congressional Budget Office, mid-February. After that Treasury would have to decide to pay some bills and not others. You can bet it would continue to pay the interest on U.S. debt even if it has to raid other budget lines. Default on U.S. debt obligations would throw the U.S. and the rest of the world into financial market chaos. Crisis #2 hits shortly after the U.S. Treasury runs out of room to finagle. The fiscal cliff deal put off $1.2 trillion in automatic spending cuts equally divided between defense spending and domestic discretionary spending—the Sequester—that were set to go gradually into effect after January 1, according to the terms of the Budget Control Act of 2011 that ended the last battle over the debt ceiling. (About $100 billion in automatic cuts would go into effect in the 2013 fiscal year that ends on September 30, 2013.) The January 1 fiscal cliff deal only postponed the cuts—it didn’t cancel them—until March 1. So sometime in the next six to seven weeks Congress will have to resolve automatic budget cuts that it has shown no ability to address in a meaningful way in 18 months or Federal spending gets whacked by $100 billion this year with more cuts to come. That’s certainly enough to take another bite out of first quarter GDP growth that economists already fear could dip to a rate of just 1%. Crisis #3 comes close on the heels of Crisis #2. The September 2012 continuing resolution that authorized spending by the Federal government expires on March 27, 2103. Unable to pass an actual budget or the appropriation and spending bills that go with it, our government in Washington has been operating under a continuing resolution that authorized spending for the first half of fiscal 2013. Unlike a failure to raise the debt ceiling—which would lead to the government paying some bills and not others—failure to extend the continuing resolution would mean that the federal government wouldn’t have authority to spend any money. Here we’re finally looking at something that would actually shut down the federal government.
- The two sides have already begun to double-down on their rhetoric. Congressional Democrats, afraid that President Barack Obama will negotiate spending cuts on entitlements, are urging the President to get tough. House Minority Leader Nancy Pelosi has said the President should invoke the Fourteenth Amendment to raise the debt ceiling by presidential order. (Section 4 of that amendment to the U.S. Constitution says “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Some constitutional lawyers—and some Congressional Democrats and some members of the Obama administration such as Treasury Secretary Timothy Geithner—have argued that this language makes the debt ceiling itself unconstitutional and gives the President the power to simply raise or ignore the debt ceiling. So far the White House, fully aware that this kind of assertion of power would provoke a constitutional crisis, has said it does not intend to invoke the Fourteenth Amendment.) On the Republican side, Senate and House leaders facing a revolt by conservative Republicans, have declared all further tax increases off the table. On Sunday TV Republican Senate Minority Leader Mitch McConnell said, “The tax issue is finished, over, completed.” That will come as a surprise to a White House that is holding to its position that any spending cuts must be balanced 1-to-1 by tax increases. All this feels like the staking out of extreme positions that marks the beginning of negotiations in Washington these days. But the distance between these positions, even if they are just rhetorical posturing, is certainly enough to make reaching any agreement a long and drawn out affair with big potential to worry the market.
That potential to worry the market is, of course, what most interests investors. Here’s how I’d handicap that worry.
From the fiscal cliff deal, we know that investors are inclined to assume that, against all evidence, U.S. politicians will find a compromise rather than wreck the U.S. economy or destroy the U.S. credit rating. I think in this case that means that the markets are likely to stay relatively optimistic until at least January 21-25.
Why those dates? They mark the next meeting of the Bank of Japan (January 21-22) and the next meeting of the U.S. Federal Reserve (January 24-25.) The Bank of Japan is widely expected to cave in to pressure from the newly elected Liberal Democratic government and announce a big program of bond buying that would push inflation toward a goal of 2% and weaken the yen. Investors will be looking to the Fed meeting for signs that, after the fiscal cliff deal and with the looming uncertainty of the three February crises, the bank intends to keep its $85 billion a month program of quantitative easing running at full throttle.
I think investors will be reluctant to do too much selling of stocks and bonds before those dates, especially since Asian financial markets are likely to be strong over the next two weeks on hopes for Japanese stimulus and on evidence that China’s economic growth is accelerating.
After that, though, global financial markets will be free to focus on the news out of Washington. Not only do I expect that news to be negative—I don’t think we’ll see a deal until after the last minute again—but I expect that Wall Street gurus and the companies that rate government debt—Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings—will keep reminding financial markets about the possibility of another downgrade to the current AA U.S. credit rating. Granted the last downgrade didn’t produce any increase in U.S. interest rates or a weaker dollar, but that was largely because the euro debt crisis made the United States an attractive safe haven. The United States doesn’t have that going for it this time since the EuroZone has temporarily “solved” its crisis.
I don’t know that this publicized uncertainty will be enough to end the recent rally and produce a significant sell off in financial assets.
I do know that the next crisis is enough to increase the odds of a sell off, especially since stocks have rallied to five-year highs. As I’ve written recently http://jubakpicks.com/2013/01/04/lessons-from-2012-for-profiting-in-the-recent-rally/, that if you want to profit from the recent rally you need to do it sooner rather than later. Before the end of the month, I think the odds will have shifted, reducing potential reward and increasing potential risk.
Given the nature of the debt-ceiling crisis, in which fears of a credit downgrade for the United States would hit both U.S. stocks and bonds (and if it got scary enough extend downward pressure to Asian and other emerging markets), cash strikes me as the best asset in the crisis. (Gold would normally be a safe haven too but gold has been in its own downtrend recently and for the moment I prefer cash.)
How much do you want to move to cash? I’d use the rules I laid out in my post http://jubakpicks.com/2012/12/27/yesterday-i-advised-raising-some-cash-in-the-uncertainty-of-the-fiscal-cliff-here-are-some-thoughts-on-sources-of-cash/ to increase cash holdings. As of this moment, I see any crisis-related downturn as a buying opportunity that I’d like to have enough cash—say 20%?–to exploit rather than as a reason to sell everything. Watch our politicians—and global market reaction to our politicians—to see if that changes.
You certainly can’t say this is a dull market.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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