Monday, October 14 2013
The debate around the debt ceiling in the US is once again dominating markets attention. The question we need to ask is whether volatility associated with this debate represents a buying opportunity or if it will present a risk of a major market disturbance.
We have noted for some time that the fundamentals of the US economy have been improving but politics continues to undermine the recovery. In terms of the underlying economy the following factors have been driving the improvement:
- A recovery in the housing market.
- An improved competitive position in manufacturing thanks to a combination of the US$, the cost of manufacturing labour not increasing for many years, low cost of energy, and the increased use of robotics further enhancing productivity.
- Monetisation of large reserves of oil and gas.
This is a great foundation for the economy and if the politicians could agree on a budget plan then we would think the markets would respond very positively. However the politicians have been struggling to agree to such a budget plan to address the large budget deficit. The reality is they need to reduce this deficit – most likely via a combination of higher taxes and reduced entitlements. The more extreme wing of the Republicans seem too reluctant to move on taxes at all and as a consequence there is a stalemate in Washington DC.
Given the political nature of the situation we don’t see it as surprising that the main political players continue the aggressive rhetoric in an effort to shore up their support base. However, the overarching factor remains that any politician or political party that were to push the US economic into default would face a very severe backlash from the voters. We think this is well known following the fall in support for the Republicans after the Clinton era shut down. An actual default would be far more severe and we suspect have far more severe political ramifications. Early polling suggests the Republicans are losing a significant level of support and that most of the blame will be attached to them. As a consequence we think they will ultimately adjust their position to re-open the Government and lift the debt ceiling. Hopefully they will have extracted enough concessions to lead to a lasting budget agreement (but this might be a little too hopeful).
The markets have seen 17 Government shut downs before and all have been resolved before any major economic damage was done. Similarly, the debt ceiling debate of 2011 caused markets to pull back and the US was even downgraded by S&P to AA, yet this turned out to be a buying opportunity.
In short, we acknowledge that a default would be very damaging, however struggle to see why either party would choose that route given it would be very damaging to the party itself. We expect continued political posturing from both sides but ultimately some sort of negotiated outcome. In the meantime, the market will continue to watch as events unfold but we think any downside will be limited given recent experience with both issues.
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