Market Scenarios After the Debt Ceiling Debate Is Over
by: Eric Parnell July 26, 2011
All eyes remain on the debt ceiling debate. While glacial like progress continues to be made, the probability still remains high that an agreement will be reached by the final hour. With this in mind, it is worthwhile to increasingly focus on how investment markets including stocks, bonds and gold are likely to respond once the debt ceiling issue is finally behind us. While the immediate response is likely more straightforward, the market may then find itself on several different challenging paths in the months ahead depending on how the legislation finally comes down.
The initial reaction upon a final debt ceiling deal is likely to be a euphoric sigh of relief. Stocks will likely seize the opportunity to take off on another rally. And assuming stocks follow the pattern shown during our most recent brushes with crisis, we’ll most likely see this rally begin to take off anywhere between 24 to 48 hours before we have the all clear that a deal is done. This initial response in stocks is understandable, as the resolution of the debt ceiling debate eliminates a major risk that is currently overhanging the market. The next steps for stocks after this expected initial burst may not be so positive, however, but more on that in a minute.
As for bonds and Treasuries in particular, they may catch an initial bid once a deal is done, but yields are already so low that it’s equally probable that they may trade flat or perhaps even sell off as investors take off the safety trade and venture back out into risk assets like stocks.
Finally, gold is likely to sell off in the midst of any debt ceiling deal. Gold has performed exceedingly well in recent days supported in part by investors seeking a hard asset safe haven from all of the uncertainty brewed up in U.S. and global investment markets by the ongoing debate. The fact that gold is lingering near overbought levels on a technical basis further supports the idea that a short-term breather may soon be in store.
But the initial response is far from the prolonged market reaction once we begin to move beyond the current debt ceiling debate. And a key to this more extended response is what is decided upon in the final deal.
The legislation resulting from the debt ceiling deal will likely place downward pressure on economic growth. This is due to the fact that a reduction in government spending or an increase in taxes has a dampening impact on an economy. As of tonight, it appears that any tax increases are off the table. But spending cuts are at the heart of the debate in order to get the debt ceiling raised. Some law makers would like to focus on spending cuts that would begin to take place immediately. Others are seeking to push these spending cuts out into the future. Adding to the debate, the credit rating agencies are demanding cuts of sufficient substance to prevent the lowering of the country’s prime AAA credit rating. How the final agreement is put together will determine the magnitude of the impact on the economy, but the net result is likely to be a dampening effect.
A decrease in economic growth would have a negative effect on stocks. Basically, if the economy slows, this will lead to an overall reduction in corporate revenue and earnings. And if the “E” starts to go down in the market “P/E,” then pressure starts to build on the “P” to also go down in order to keep valuations at current levels. But unfortunately for stocks, valuations typically shrink during periods of economic weakness, as investors have less confidence about the ability of companies to predictably make each dollar of earnings. Taking this one step further, the more immediate the spending cuts, the more pronounced the drag on stocks is likely to be. And while putting off spending cuts until later would actually be more favorable for stocks in the short term, the uncertainty bred by the U.S. fiscal situation being allowed to fester has the potential to create an even greater problem longer term.
A decline in economic activity would be bullish for high-quality bonds including Treasuries. This is due to the fact that investors typically seek the implied safety and stability of the Treasury market during times of economic weakness. Even today, despite all of the uncertainty surrounding the debt ceiling debate and the talk of possible default, the Treasury market remains a safe haven destination for capital. Thus, if the current debt ceiling debate were to result in the sense that the United States is truly getting serious about reducing spending, balancing our budget and getting our fiscal house in order, this would be all the better for the Treasury market. Conversely, if it were perceived that the government is just kicking the can down the road with a debt deal that lacks any real teeth, this would add to the long-term downside pressure that has been building in the Treasury market for some time. This would be particularly true if the U.S. credit rating is downgraded.
Any economic deceleration will likely add to the already bullish case for gold going forward. And unless legislation is put into place that greatly increases confidence that the United States is beginning down a path to clean our fiscal finances, the U.S. dollar is likely to remain weak and perhaps weaken even further, which would add to the gold tailwind.
One additional factor beyond the debt ceiling debate may mute any initial euphoria and also add to the pressure on markets going forward. This is the situation in Europe. Due to all of the focus on the debt ceiling debate, the fact that Treasury yields are back on the rise again in Europe flew a bit under the radar today. We are only four days removed from the Euro Zone’s latest bazooka shot and 10-Year government yields are already back above 6%. While it is presumed that the leaders of the European Union bought themselves some time with their latest rescue plan, if the situation begins to quickly descend back into crisis, this would amplify the downside pressure on stocks as well as the upside pressure on Treasuries and gold.
In anticipation of a conclusion to the debt ceiling debate in the coming days, I remain long TIPS (TIP) and Treasuries (IEI), (IEF), (TLT) and Gold (GLD). In regards to gold in particular, I am watching for any meaningful sell offs to add to positions. As for stocks, I remain focused on high-quality defensive sectors including food, household products and utilities. And just like with gold, I am selectively looking to pick up high- quality stocks that are severely sold off along the way.
While it will be a relief to put the debt ceiling debate behind us when it is finally over, more hard work lies ahead for the global economy and markets.
Disclosure: I am long IEI, IEF, TLT, TIP, GLD.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
