What to tell clients about the shutdown, debt ceiling issues

A primer for advisers on the most pressing concerns

Oct 10, 2013 @ 2:02 pm

By Jeff Benjamin

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With Washington political hostility launching both a partial government shutdown and another bitter fight over how much money the country can legally borrow, the financial markets have been in a relative state of flux while waiting for a resolution.

The dynamic nature of the situation was on display in the equity markets Thursday as the S&P 500 spiked nearly 2% on talk that Congress might be finding some middle ground with President Barack Obama on the debt ceiling issue.

Find out how investors are reacting to the government shutdown and debt default issues.

With that in mind, here are some of the concerns that might be most pressing to financial advisers' clients:

1. What is the likelihood that the United States will default on its debt obligations?

Based purely on the fact that a U.S. default would be so catastrophic that it would immediately disrupt the global economy, most market watchers describe the risk of default as very unlikely.

“This is a manufactured political crisis, and because of that, it is incumbent on investors to look past this and to the true fundamentals that drive markets,” said Douglas Cote, chief investment strategist at ING U.S. Investment Management.

For context on the magnitude of a U.S. default, consider that the U.S. dollar represents 75% of the more than $5 trillion worth of daily global currency trading.

“If all of a sudden, we're not paying our debt, then global currency transactions could effectively freeze, and you don't even want a pause because that leads to deflation and a depression,” Mr. Cote said. “Default is not going to happen.”

Treasury Secretary Jacob Lew has stated that the federal government has only enough credit available to meet the Oct. 17 debt payment of about $30 billion. Other analysts have suggested that the October payment date is less significant than a larger November payment deadline.

2. How does the government shutdown affect the country's ability to meet its debt payments?

The partial government shutdown that began Oct. 1 isn't directly related to the debate over raising the government's borrowing limit beyond the current level of $16.7 trillion.

The shutdown, which is the result of Congress not agreeing to pass a budget or a continuing resolution to fund government, prohibits discretionary spending but not mandatory spending or debt service, according to Moody's Investors Service.

Although the shutdown initially rattled the financial markets, attention quickly shifted to the looming debt limit debate, which has been linked to an Oct. 17 debt payment deadline.

Since the start of the shutdown, the S&P 500 has seen increased volatility and reduced trading volume but was essentially unchanged over the first eight trading days of the shutdown.

Even without factoring in the more significant issue of default risk, the shutdown generally was considered to be negligible at worst and an investment opportunity at best.

“I tell all my clients that the average shutdown lasts about five days and that historically, the market usually responds with an 18% increase over the next six months after the shutdown,” said Theodore Feight, owner of the advisory firm Creative Financial Design.

3. Does all this budget and debt limit negotiating suggest new threats of deflation or inflation?

In the worst-case scenario, a U.S. government default would be a deflationary event.

“If the government says it isn't going to pay its debt or is going to pay less of its debt, that means there is less money in the system than investors had anticipated in terms of income, and that leads to less consumer spending, which leads to deflation,” said Brian Frank, manager of the Frank Value Fund. “Of course, unlike a country like Greece, we control our own printing press, so a deflationary environment would mean quantitative easing to the 10th power, which would be more of what we already have.”

Thus, barring an actual government default, the risks of either inflation or deflation are seen as relatively benign.

On a year-over-year basis, the U.S. economy is growing at a pace of about 1.5%, which is still below the Federal Reserve Board's target growth rate of at least 2% inflation, despite a quantitative-easing program that includes spending $1 trillion a year on Treasury bonds and mortgage-backed securities to try to trigger inflation.

4.What does all this mean for the prospects of tapering of the five-year QE program?

Even though Fed Chairman Ben S. Bernanke during the summer led the markets to believe that some form of tapering would begin last month, it is now thought that the Fed might have held back in light of the looming debt ceiling fight.

“This kind of uncertainty will create slower economic growth, so the Fed might have been a little ahead of the curve in that regard,” Mr. Cote said.

The outlook for tapering the current pace of $85 billion worth of monthly bond purchases is that it might not start until next year. One wrinkle in that outlook is Mr. Obama's nomination this week of Janet Yellen as the next Fed chairman.

The nomination still needs Senate approval, but she is considered to share dovish leanings with regard to monetary policy, which could support more, rather than less, quantitative easing.

5. With so much up in the air, is this a good time to get out of the markets?

Thursday's equity market rally is a perfect example of why investors should never try to invest based on Washington politics.

Although market volatility has increased since the Oct. 1 government shutdown began, on a purely fundamental basis, the equity markets remain attractive.

If investors are holding a lot of cash, this might be a good time to start dollar cost averaging back into the markets, according to Adam Patti, chief executive of IndexIQ.

“We already gave back all of September's gains, so this is a time to get back into an asset allocation strategy,” he said. “The politicians are just playing games right now.”

With an outlook for a solid third-quarter earnings season, which started this week, there is reason to think that the fourth quarter of the year will be strong, as well, according to Greg Sarian, managing director at The Sarian Group.

“There are still a lot of retail investors that have not bought into this recovery, and this could be a good opportunity to purchase stocks at lower prices,” he said.

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