The near term market risks preoccupying the media are prospects for difficult US Political negotiations over the debt ceiling, which begins to bite at the end of February. The U.S. reached the statutory debt limit of $16.394 trillion on December 31. The Treasury is utilizing extraordinary measures to ensure the federal government’s normal functioning until the end of February, when it will run out of room to maneuver. This may add volatility to the market, but the end point will not be a Treasury default, so markets will not price in extended economic weakness. – Note: No other major economy requires separate legislation to authorize a specific level of outstanding debt. Elsewhere, when a budget is passed, there is an implicit authority to borrow whatever money is required, even if the deficit exceeds expectations. But the problem, unfortunately, is bigger than just the debt ceiling because Congress has not passed a budget since 2009. Thus, the most promising part of the new bill that suspends the U.S. borrowing limit until May 19 may be that the House legislation, tries to force the Senate to adopt a budget resolution by withholding congressional pay unless both chambers approve a budget by April 15. – Across-the-board spending cuts (sequestration) will kick in March 1 in the absence of a political deal. However, that would only add 0.4% of restraint.
Conditions are in place for a nasty political fight that goes down to the wire. Republicans will demand cuts to entitlement programs as quid pro quo for raising the debt ceiling and watering down the sequester. Democrats will not accept cuts to entitlement spending without greater tax revenue. After acquiescing to higher taxes on upper income earners during the fiscal cliff negotiations, Republicans are reluctant to agree to further tax increase. A grand bargain that includes long term fiscal reform appears unlikely and it may take market pressure to force an agreement on the debt ceiling and the sequester. Thus, expect an acrimonious negotiation process, but also expect U.S. politicians to ultimately come to a deal to raise the debt ceiling. Unfortunately, the reforms needed to put the U.S. on a long term sustainable fiscal path are unlikely. Even more unfortunately, no one is tackling the tough issues of making government more effective and efficient by reducing friction, fraud, and unnecessary processes. None-the-less, positive stock market sentiment hints at a complacency in the marketplace.
But rather than just blaming complacency, the market is doing what it is supposed to and looking ahead six to twelve months. The S&P rose through November and December, and even though we technically crossed the fiscal cliff deadline on New Year’s eve, panic did not ensue. Rather, the marketplace chose to treat it as a non-event. Of more concern are developments that might undermine nascent global growth. To gauge sustainability, we are monitoring: 1) Growth in emerging Asian exports and industrial production, which correlates closely with industrial commodity prices; 2) The possibility of Chinese monetary tightening in response to inflation; 3) Euro zone macroeconomic indicators which are finding some stability; and 4) Global interest rates. Closer to home, we are monitoring commercial real estate values and seeing an uptick in architectural projects.
Expect January to be a strong month as fiscal cliff issues fall to the wayside and the market looks past the political malaise in Washington. The U.S. deleveraging cycle is at least half over, thus the drag on growth from household deleveraging should diminish. Real home prices are no longer falling, down payment rates have moved up, and loans falling into delinquency have decreased to the lowest level since late-2006. This means that mortgage deleveraging should become more organic in nature, which, in turn, means that it will be less of a drag on spending. Outside of housing debt, the pace of deleveraging should also diminish over time; as a share of disposable income, consumer credit has fallen to mid-1990s levels. The only area of household debt that has continued to expand is student debt, which has more than quadrupled since 2003. Given that the bulk of student debt is either held directly or guaranteed by the government, this is a worrying development for taxpayers. Nonetheless, as a whole, there has been meaningful progress in household deleveraging. This means that a higher pace of growth in 2013 is possible.
Michael Ashley Schulman, CFA