Are Markets Whistling Past the Graveyard?— Weekly Market Review
The first Friday of every month is something of an event for economists like me. That’s the day the Department of Labor releases its monthly employment data, providing copious data on non-farm payroll gains or losses, labor force participation, unemployment and under-employment rates, and so on. So this week, I should be writing about how the U.S. job market fared in September and what it means for the economy as a whole. Thanks to the government shutdown, however, there was no payrolls report last week. I’m of two minds: on the One hand, I do want every shred of evidence on the economy’s progress; on the other, I recognize that we often pay too much attention to recurring statistics (which are often revised) and fail to see larger trends, such as what I believe to be an economy that’s recovering from the financial system’s woes of the past six-plus years.
Of course, other segments of society are feeling the effects of the shutdown much more acutely than economists are, especially people who rely on shuttered government agencies for access to nutrition, education, vital services, or their salaries, for example. Because of piecemeal funding legislation, furloughed federal workers now appear likely to eventually receive back pay eventually, and most defense civilians will probably return to work soon.
The shutdown is probably only subtracting a modest 0.1% directly from nominal 4th quarter GDP growth per week. Indirect effects could worsen the damage, however, especially if the shutdown stretches on for a long time. Homebuyers may have to wait for FHA loan approvals, which could put a damper on home sales; applications for various benefits and services, such as Medicare and Social Security could be delayed; and contractors may not be paid on time, causing their businesses hardship.
The fact is that the shutdown isn’t good for anybody, save perhaps the odd representative or senator who can make political hay out of it. The longer it goes on, the more uncertainty it creates, and both businesses and financial markets have an aversion to uncertainty. Investors have thus far avoided much in the way of punishment, though it’s unclear how long markets will tolerate gridlock—especially considering that the situation is poised to become much worse in about ten days.
Dancing on the Ceiling
On or about October 17, according the U.S. Treasury, the country will no longer be able to meet its financial obligations unless Congress agrees to raise the $16.699 trillion statutory debt limit, known as the debt ceiling. Over the next month, government revenues should total about $222 billion, and it must make payments of about $328 billion. Without the authority to borrow money, it cannot pay roughly one-third of those bills. While the idea of adding to our $16.8 trillion federal debt is unpalatable, these funds are needed to pay for the programs to which Congress has already committed the nation. And if the government shutdown is harmful, breaching the debt ceiling could be a true calamity, mainly because it raises the possibility of defaulting on our bonds, but also because it could result in a sudden, massive cut in spending. An abrupt spending cut of roughly 30% would surely tip the economy into recession.
I continue to expect lawmakers to reach a deal to raise the debt ceiling before the clock runs out, but the risk of a more negative outcome, small though the risk may be, does exist. Washington’s recent playbook had been to wait until the last possible moment before resolving a standoff, but lawmakers’ failure to avert a government shutdown last week reinforces the still small possibility that lawmakers could stumble into a debt ceiling crisis.
What’s the Backup Plan?
The Treasury has few good options if it runs out of money. Some have suggested that the president could sidestep the debt ceiling by invoking the fourth section of the 14th Amendment, which reads, in part, “The validity of the public debt of the United States, authorized by law…shall not be questioned.” President Obama has publicly ruled out such an option, as he did during the 2011 showdown. In any case, his opponents would almost certainly take the issue to court. And if new “14th Amendment”-based bonds were legally questionable, who would buy them? It’s not a feasible solution, at least in the near term.
Another option would be for the Treasury to prioritize its payments in order not to default on bonded indebtedness. This option, too, is highly problematic. The Treasury will likely be able to prioritize interest payments on the debt over all other payments as they are processed under a different computer system. Prioritizing all other payments may not even be technically possible without a lot of time to prepare. The U.S. government has an expansive array of integrated payment systems for processing things like Social Security checks, interest payments, payrolls, invoices, and so on. The Treasury Department receives about 2 million invoices a day, and the system is programmed to pay them automatically upon verification of the charges, in the order in which they are received. Trying to re-jigger such a massive system virtually overnight would likely result in chaos. Additionally, there is the question of which payments get priority. Payments to veterans? Small businesses with contracts with the federal government? What about Social Security checks, keeping in mind that many seniors rely on the programs as their primary source of income? What about education funding? Given that such an option has never been attempted, nobody at the Treasury can say for sure what would happen in the event. Nobody even knows for sure whether prioritizing payments would be legal. As with invoking the 14th Amendment, trying to pick and choose which payments to make is unlikely to be a viable solution.
There are other options floating around, from using I.O.U.s to pay some of the government’s bills to minting a trillion-dollar platinum coin, but none of them appears particularly feasible, whether legally, politically or logistically. Ultimately, any course of action other than paying all the bills on time and in full risks calling into question the reliability of the U.S. government, which has spent more than two centuries building a sterling reputation for creditworthiness, a creditworthiness on which the global financial system hinges.
Walking a Fine Line
In recent days, the Speaker of the House has indicated that he would not allow a default to happen, and that he would be willing to pass a debt ceiling increase with Democrats’ votes, if necessary. On the other hand, I’d note that he and other Republicans are still using the debt ceiling as leverage as they try to extract concessions from the Democrats. I’d rather see less threatening tactics, but if major tax reform or serious consideration as to what the federal government should and should not do results from this “double dare” environment, the nation stands to benefit. We will see, as the parties trade gambits, how the likelihood of a solution—or breach of the debt ceiling—changes over the coming 10 days. As the man said, “Politics ain’t beanbag.”
Markets, so far, seem to be taking the showdown in stride. Since September 30, the S&P 500 Index has gained 0.7%,1 the yield on the 10-year Treasury has risen by 3.5 basis points,1 the U.S. dollar has fallen slightly against a basket of foreign currencies,1 while gold, theoretically a hedge against tail risks, has actually dropped by just over a percent.1
Yet, other potential signs of stress are emerging. The CBOE Volatility Index, the VIX, known as Wall Street’s “fear gauge,” has spiked higher in recent days, as has the cost of insuring U.S. debt (though the market for Credit Default Swap (CDS) “insurance” derivatives is thinly traded and easily swayed by speculators). Similarly, the yield on the 1-month Treasury bill due October 31 has soared (albeit from a miniscule base), as investors demanded a growing premium in return for the emerging risk of a delayed interest payment. Bear in mind that on October 23, the Treasury has to make $12 billion in Social Security payments, followed by a $6 billion interest payment due October 31, and then a $67 billion payment for Social Security, Medicare, disability payments and military pay on November.
What It Means for Investors
For now, markets appear to share my faith that lawmakers will resolve the debt ceiling in time, but investors may grow more restive as the deadline approaches, particularly if signs of progress are few. As I’ve written in recent weeks, any sell-off could represent a solid buying opportunity, if the post-2011 showdown rally is any guide. Ironically, if we get sudden austerity but no default, the economy will take a body blow, but Treasuries will likely rally. It’s prudent, however, to make accommodations in your portfolio for “tail risks”—the risk of highly unlikely but high-impact outcomes. As part of OppenheimerFunds’ New 60/40, we recommend a modest allocation to gold, which may help cushion the blow to a portfolio from such tail risks—particularly that of default—not because we think a default will occur, but because a small allocation may provide the reassurance needed to keep the growth and income portions of our portfolios intact during uncertain times.
1. Source: Bloomberg, 10/4/13. Past performance does not guarantee future results.
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