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Deal or No Deal?— Weekly Market Review

Jerry Webman, Ph.D., CFA

Chief Economist

Political posturing in Washington D.C. continued to buffet financial markets last week, with financial markets soaring as the outlines of a potential deal began to emerge. Thursday recorded the second-best day for stocks in 2013 on reports that lawmakers were making progress on a deal that would, at the very least, delay a potential breach of the debt ceiling and perhaps set the stage for a resolution of the showdown now gripping the capital.

While the government shutdown has caused hardship for many, its direct effect on the overall economy appears muted so far. Estimates of the damage it’s causing are generally in the tenths-of-a-percent of GDP per week range. Clearly, the struggling U.S. economy doesn’t need any self-inflicted dead weight, but there’s little evidence that a shutdown alone could tip the U.S. into recession unless it goes on for quite a while. 

The debt ceiling debate remains the real threat. Simply put, Congress has approved spending that exceeds the government’s revenues from taxation and must borrow to make up the difference. In the absence of a high enough debt ceiling, the government will not be able to pay for all the commitments it has already made, whether to bond-holders, social security recipients, veterans, contractors, or anyone else to whom it has a financial obligation. I’ve discussed the dangers of breaching the debt ceiling at length in this space and others; suffice it to say that the consequences of a default on interest payments would be terrible, and even if interest payments were to be prioritized, failing to raise the debt ceiling could result in a sudden stop to much of the government’s spending, which could easily tip the economy into recession.

It’s unsurprising, then, that financial markets cheered, and volatility eased, late last week on news that the rough outlines of a resolution to the standoff were taking form. While the weekend has produced reports of a number of different proposals and refusals originating in both the House and Senate, the most likely outcome is a deal to raise the debt ceiling for a certain period of time and re-open the government in exchange for negotiations and possible concessions  over taxation, spending and health care reform. As I wrote in a blog post last week, we could see a deal that includes items Republicans favor, such as changes to Social Security cost-of-living adjustment methodology and/or additional income verification for health benefits, plus the repeal of a tax on medical devices, along with greater flexibility on sequestration spending limits, which would appeal to Democrats.

While the potential for bad outcomes, including one that sets the stage for paralyzing showdowns over the debt ceiling, definitely exists, the possibility remains that at the end of all this drama, the U.S. winds up with less short-term austerity and some progress toward containing growth in long-term entitlement spending, which would be beneficial for the economy now and in the future. Stranger things have happened.

3Q Earnings Season Kicks Off

With the D.C. follies receiving so much attention over the last few weeks, some may have overlooked that third-quarter earnings season is now underway. As of last Friday afternoon, a mere 32 of the constituents of the S&P 500 Index had reported results. Among those, 66% posted better-than-expected earnings (well above the long-term average) and 53% reported better-than-expected sales (slightly below the long-term average).

As has been the case for several quarters now, generally leaner-running companies have fewer avenues through which to drive earnings besides increasing sales, but with unemployment still elevated, wages basically flat, and capital spending by business still soft, growing sales remains a challenge for many businesses. Slowing economic growth in emerging markets and little more than the appearance of a few “green shoots” in the Eurozone contribute to the list of challenges, especially to U.S. companies that export into those markets. Valuations, at 16.7x trailing 12-month earnings for the S&P 500 Index, are richer than they were only a year ago, but they still don’t appear unduly stretched by historical standards and could even expand if companies’ prospects improve. Going forward, I expect to see the market increasingly differentiate between companies that both manage capital efficiently and grow sales organically, and to reward the winners. In such an environment, selectivity becomes crucial for investors.

Yellen Nominated for Fed Chair

In what would normally have been the top economic story of the week, the President nominated Janet Yellen, Vice Chair of the Fed’s Board of Governors, to be the next chairwoman of the Federal Reserve. The move, assuming Congress approves her nomination, ensures continuity in the central bank’s policies. Though I expect a heated confirmation debate in the Senate, there’s no doubt that she’s qualified for the job, having previously served as head of the San Francisco Fed and on the Federal Reserve System’s Board of Governors. And while she has a reputation as being something of a dove, she has a record of pushing to rein in inflation during the Greenspan years. Her academic focus on unemployment is also relevant, for obvious reasons. Finally, I’d add that her nomination, instead of Larry Summers’, sidesteps an important problem that I recently highlighted: Picking Summers, the favorite of White House insiders, might have raised uncomfortable questions regarding the Fed’s independence, the importance of which is difficult to overstate.

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