|Summary: The US shutdown has spooked markets, and there are broader concerns that a debt default would not just stall the recovery process, but send the US back into a full blown recession. But such a scenario is unlikely, despite such rhetoric from the Federal Reserve. The US Constitution effectively prohibits a default from happening.|
|Key take-out: Signals suggest that the recent modest slide in equities is unlikely to turn into a major correction. But if it does, investors should embrace this as a golden opportunity for profit.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
Even without the latest budget debt drama in the US, investors are probably right to think that the US economy is taking a turn for the worse.
This view was probably best summed up by the Boston Federal Reserve president Eric Rosengren, who suggested just this week that economic growth was tepid, jobs growth weak, and inflation so low that it risked missing the inflation target on the downside.
People are now talking of a Quantitative Easing (stimulus) taper delay into 2014, and that’s before we even start talking about the fallout from the US government shutdown – which I’ll get on to in a minute.
The important thing to note is that the Fed, and it is not alone, is sending a strong signal that it is unsure about the strength and durability of the recovery. So, for instance, while it currently expects above trend growth next year, it has already downgraded growth projections – by about one-third of a per cent this year and next.
Of course, the shutdown need not be serious, and chances are it won’t be. Having said that, the government has been shut down for three days, with no sign of breakthrough. Moreover, the market reaction to date has been extremely modest. Sure, US stocks have declined in nine of the last 11 trading sessions, but cumulatively this only amounts to a fall of 2% or so.
Remember that the government doesn’t literally shut down – some non-essential parts do, but by and large the wheels of administration still turn, if just more slowly. We don’t know how long it will last or what the end game will be – although it must be emphasised that a US default would be unconstitutional.
One of the more widely publicised estimates of the ‘cost’ to the US economy of the shutdown is that each day the government is closed, the economy loses $300 million – although presumably the government saves $300 million per day as well. Anyway, if that’s accurate and assuming a relatively lengthy shutdown of say 21 days, which if that occurred would equal the longest shutdown to date (under Bill Clinton in 1995-96), it would equate to a little over $6 billion lost. For a $14 trillion economy, that’s nothing. It’s not even 0.1% points off growth.
Another way to get a sense of magnitude is to compare it against the “fiscal cliff”, or the sequester. Recall that the sequester was to reduce spending by $85 billion in the fiscal year 2013, which for the US ended in September. That, in turn, was to reduce GDP by 0.6% points and lead to 750,000 fewer jobs – or from the date of the sequester, average monthly jobs creation of 70,000. The reality, and as I explained to Eureka subscribers at the time (Don’t fall over the fiscal cliff), is that the sequester was largely invisible. GDP growth is currently above trend and average monthly jobs growth is more than double what was thought likely under the sequester – almost 150,000 per month. Indeed, the sequester brought no noticeable change in jobs growth, or economic momentum more broadly. And that impact is over 10 times what is, in a long shutdown scenario, likely.
The unfortunate thing, especially for retail investors, is that recent Fed rhetoric and commentary from policymakers around the globe is creating a sense of alarm. The US Treasury says the result could be catastrophic, worse than the global financial crisis off 2008, and even lead to a US default. Now I’m no constitutional lawyer, but my understanding is that a US default is in fact, by the Fourteenth Amendment, unconstitutional. It states quite clearly that:
“the validity of the public debt of the United States, authorized by law, including debts incurred for payments of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”
Now this doesn’t mean, according to White House lawyers, that the debt ceiling can be lifted without Congressional approval – although that is a legally grey area. But it does mean that the US cannot default on its current debt – without presumably the President, and the US Congress, breaking the law and the President, for his part, being impeached for his efforts. So, and despite the alarmism of policymakers, I suspect an actual default is a very low probability event. In any case, the US government though the Fed and public pension accounts is the single largest holder of its own debt, so it would only be defaulting on itself – which doesn’t make a lot of sense.
But what options are there, assuming no deal? Well, the way I see it, there are four main realistic options, though the list isn’t exhaustive:
- The White House could raise the debt limit anyway and propose that the debt limit is unconstitutional – citing the Fourteenth Amendment (something it has said it won’t do as yet) and face down the inevitable legal challenge in the courts. Indeed, there are many high ranking politicians, policymakers, lawyers etc. who suggest Obama should do just this. It’s being taken very seriously.
- Slash spending. The Congressional budget office projects a budget deficit of $582 billion for this current fiscal year – and that’s what spending would have to be cut by. That would equate to about 3.5% of GDP, and because it would involve an actual cut in spending would almost certainly cause a recession.
- Make a phone call to the Federal Reserve as the single largest holder of US Treasuries and negotiate debt forgiveness or forbearance – i.e. write off its debt or stop interest repayments or something like it – and then get them to print more money. Sounds awful but it’s entirely legal, and while it would make the Fed temporarily insolvent, there are few real practical implications from this.
- Sell down some assets like gold.
Realistically though, I don’t think any of the above will be required and a deal will be cut. But even if I’m wrong on that and the drama intensifies, the outcomes again need not be bad. In fact, I would suggest to investors that if events do take a turn for the worse, and markets panic, it would probably be a good buying opportunity.
The reason for that is because, in the background, while the Fed is talking things down and everyone is focussed on the US shutdown or a default, and policymakers around the world feel the need to hype up the hysteria, the US economy actually looks to be accelerating from an already above trend pace of growth.
Not all indicators are showing this of course, but then again not all indicators were created equal. The ISM index is one of the best indicators of US economic growth, and it’s at a two-year high. I trust this one. When it goes down, I worry, and when it goes up, that’s good. Especially when it’s accompanied by other key business indicators such as the Philadelphia Fed Index, which surged to 22 in September from 9. Indeed, the six month outlook looks even better by that index.
Throw in the fact that US house prices are rising at a 12% plus annual pace, consumer credit growth is very strong, that housing starts are rising, durable goods orders lifting and, importantly, new jobless claims have remained at a six-year low when it was widely thought it would spike higher. Well then I think, on the balance of probability, things are getting better not worse.
Certainly the Fed’s fears have little empirical support, and I suspect much of the rhetoric from the Fed is based more on the fiscal position of the United States rather than its economic state.
For investors wondering whether the recent modest slide in equities may turn into another full blown correction – the signals thus far are that it won’t. Mind you, if it does, then investors should embrace this as a golden opportunity for profit.