Political risk - good for bonds but not for equities

Introduction

Last week we looked at some of the issues that were concerning financial markets. While we have been highlighting political risk in many of our communications, the markets have generally failed to price political risk in until very recently. We explore the forthcoming US political decision-making season in the following three ways:

1. Summarise the FOMC comments as well as data released last week.
2. Consider the probable time line of US political events this week, between the US Senate and the US House of Representatives.
3. Compare a US government shut-down this time, to 1995.

1          FOMC Summary

In many ways, the decision by the FOMC, to delay tapering, took a lot of courage. Generally the FOMC and their expectations, remain the mean, between a financial market that remains wildly optimistic, in terms of growth expectations, and economic reality, which just keeps failing to live up to these expectations. James Bullard, the President and Chief Executive Officer of the St. Louis Federal Reserve Bank, has commented on this failure, of reality to live up to optimistic behaviour. Specifically, he said that FOMC expectations remain somewhat optimistic and that the FOMC keeps on revising down growth on their own forecasts. This may be because, among other things, that the FOMC is being continually influenced toward having higher expectations, by excessive optimism from a financial market that is incentivised to sell risky assets.

Generally, the FOMC refrained from tapering for three main reasons:

1. Growth and unemployment are “yet to provide sufficient confirmation” that the baseline assumptions about growth, unemployment, and inflation will be hit.
2. The “rapid tightening of fiscal conditions” threatens the baseline forecasts, which means that higher longer term interest rates are crimping growth in the housing market, among other markets.
3. The debt ceiling debate may impact perceptions about baseline forecasts as well.

While the market wants certainty on the issue of tapering, the fact is that there is no certainty. Economic recovery remains fragile, and the return to “normality” is far from assured. In terms of future expectations, we expect more of the same; current growth estimates will fall, yet again in December and current expectations of tightening should be moderated again and pushed further into 2016 from 2015. Overall, the following extract from the press conference, given by Chairman Bernanke, summarises the FOMC position well,

... in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data does not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction. Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases ([Emphasis added] pp.4-5, Chairman Bernanke’s Press Conference Opening Statement Preliminary, September 18, 2013).

2          Political risk, a possible time line

It is important to note the above reference to the “upcoming fiscal debates”, by Chairman Bernanke. Specifically, there are two hurdles here:

1. The government appropriations approval that needs to be approved before the midnight on September 30.
2. There is the debt ceiling issue that needs to be approved by mid to late October.

It seems that the main issue is what the Republicans refer to as “ObamaCare”, where Republicans do not want the reform to be implemented, nor funded by the US government, or both. “ObamaCare” is a term for the “Patient Protection and Affordable Care Act”, signed into law by US President Obama on 23 March 2010; the most significant regulatory change to US healthcare since the passing of Medicare and Medicaid in 1965. As we have said many times, the market will become concerned about government appropriation funding and the debt ceiling.

Importantly, the passage of a House vote on the approval of the budget, excluding “ObamaCare”, is the first instalment of what now threatens to be a complete US government shut-down. The following represent, most probably, the next few steps, as of 24 September 2013:

Step one: A bill, which excludes ObamaCare, to go to the senate for approval.

Step two: Senator Harry Reid (Democratic Senate Majority leader) takes out the “ObamaCare” exemption and then sends the amended bill back to the House, sometime this week.

Step three: The House then considers the adjusted Bill, with very little time left, around Wednesday to Friday.

Step four: Boehner (Republican Speaker of the US House of Representative) will then try to lead the House towards approving the adjusted Bill from the Senate, and here is the problem. It is likely that Boehner will not convince the house to approve the senate adjustment, and a shutdown then occurs. We would have thought that this was improbable, but the current disagreement between parties is probably worse than it was in 2011.

Step five: Market concern will increase looking toward a shut-down on midnight Monday, after continued debate on the weekend (Tuesday morning Sydney time).

These possible steps are what financial markets are increasingly worried about, as the threat of a government shut-down will impact perceptions of growth. We argue that this is why the FOMC mentioned the issue of the Washington debate recently; it an important part of what the FOMC is planning for over the next few months. As these concerns intensify, then they will trim growth expectations and that will then impact the FOMC, in terms of rate decisions.

In other words, FOMC officials rarely waste time by mentioning irrelevant facts.

3          Will a shut-down be worse than 1995 for the economy?

Now, even Republicans are warning other Republicans not to force a government shut-down, as this shut-down will be worse than the experience of 1995, as Karl Rove, who was a senior advisor and deputy chief of staff during the G.W. Bush administration, indicates below,

A shutdown now would have much worse fallout than the one in 1995. Back then, seven of the government's 13 appropriations bills had been signed into law, including the two that funded the military. So, most of the government was untouched by the shutdown. Many of the unfunded agencies kept operating at a reduced level for the shutdown's three weeks by using funds from past fiscal years.

But this time, no appropriations bills have been signed into law, so no discretionary spending is in place for any part of the federal government. Washington won't be able to pay military families or any other federal employee. While conscientious FBI and Border Patrol agents, prison guards, air-traffic controllers and other federal employees may keep showing up for work, they won't get paychecks, just IOUs…

The desire to strike at ObamaCare is praiseworthy. But any strategy to repeal, delay or replace the law must have a credible chance of succeeding or affecting broad public opinion positively.

The defunding strategy doesn't. Going down that road would strengthen the president while alienating independents. It is an ill-conceived tactic, and Republicans should reject it.

Now, even a last minute deal will then make the markets wake up, as they then focus on the debt ceiling debate, to be resolved mid to late October [Emphasis added] (Karl Rove: “The GOP’s Self-Defeating ‘Defunding’ Strategy: It will only strengthen the president while alienating independents”, Wall Street Journal, Opinion, 18 September 2012).

Conclusion

In summary, a government shut-down seems likely at this time. Either the actual shut-down, or the threat of a shut-down, will begin to damage perceptions of growth. Even if the shut-down is avoided, the current tension, between the Democrats and the Republicans will begin to depress perceptions of growth into October, as the debt ceiling will be the next hurdle for financial markets. In other words, the debate on government appropriations, which will transpire this week, is just the start of a very difficult period for political decision-making in Washington; a period that will take some toll on perceptions of growth.

While all this should lead to a decline in perceptions of growth, there remain two clear investment implications from these developments. On the one hand, lower perceptions of growth are, in most situations, a positive for bonds, as rate increases are delayed to even the more distant future. On the other hand, lower growth perceptions remain a significant negative for equities.