Binary situation

by: Han de Jong

The US federal government shutdown has reduced the daily data stream, but the news flow about the fiscal situation has made up for it. Polarisation in US politics is worrying and it cannot be ruled out that negotiators may fail to reach an agreement. While there is some nervousness in financial markets, most participants appear to assume that an eleventh hour solution will be reached. We are no different.

Dysfunctional politics; US fiscal position much improved short term

Developments in the eurozone have caused huge stress in financial markets in recent years. We all remember deals on support packages for several member states being reached somewhere between Sunday evening and Monday morning in order to maintain the integrity of the euro before markets in the Far East opened. This time, it is US politics that is causing stress. The extreme polarisation between Republican and Democrat negotiators and, it has to be said, differences within the Republican ranks are threatening to lead to a default by the US.

All of this would not be possible in Europe for two reasons. First, no European country establishes an absolute debt ceiling by law which has to be raised from time to time in order to allow the government to continue to borrow.

Second, there is a difference between how eurozone members on the one hand and the Americans on the other assess the fiscal situation. Had the US been a eurozone member, it would now be congratulated and serve as an example for other countries, as the budget deficit has shrunk impressively in recent years. The US deficit reached a peak of close to 10% GDP in 2010 but has now fallen below 4%. That is still above the 3% threshold we apply in the eurozone, you might say, but the deficit reduction is impressive all the same. It has been achieved by a combination of what I call ‘passive austerity’ (which is simply the expiration of stimulus measures taken earlier), continued, albeit modest, economic growth, and (active) austerity – as taxes were raised and spending cut. There is more. US nominal GDP has grown at an annual pace of around 4% in recent years (though growth has actually fallen to just over 3% this year), which means that the debt-to-GDP ratio is more or less stabilising, and any further progress in reducing the deficit will lead to a decline of the debt ratio. Many eurozone countries would be very happy to achieve that. So why all the bickering in the US?

US policymakers take a longer-term view of public finances than is typical in Europe. Of course, eurozone members’ fiscal position is also assessed on the longer-term sustainability, but more emphasis is placed on ‘next year’s numbers’. The short-term outlook for the fiscal position in the US is looking good, but various entitlement programmes and trends in several other spending categories suggest that the deficit will widen materially a little further out. It is, of course, wise to look at longer term trends, but not – in my view – if that leads to a deadlock that is threatening to cause significant economic instability. The fact that the debt ceiling needs to be raised from time to time offers politicians the possibility to blackmail one another.

This is a binary situation. The debt ceiling is either raised on time or it is not. A sigh of relief will be in order if the debt ceiling is, indeed, raised. If that does not happen, the future is unclear. It could mean that the US government might, at some stage, fail to make debt service payments and, hence, formally be in default. It is clear that the US government is not going bankrupt. So if all market participants keep their cool, nothing much should happen. However, the longer it takes, the trickier it will get. Many market participants are not allowed to hold paper in default and must sell. Should that happen in size, then markets could get seriously stressed, as pricing in many financial markets is ultimately based on pricing in the US government debt market. In addition, US government debt is used as collateral in the repo market, which is arguably one of the most important financial markets. It is unclear what the consequences will be for this market should the US government default. Last week saw an early sign of dislocation in markets as the yield on one-month US T-bills rose above one-month Libor, implying that banks are considered a better risk on a one-month horizon than the US government. This is the ‘negative TED-spread’ market commentators have highlighted recently. While this dislocation deserves the attention it gets, we must not exaggerate it either. It is not as though market participants are panicking. The three-month TED-spread is still positive.

At the end of the day investors must make a choice here and the choice is binary. You either assume that a budget deal will be done in the end and everything goes back to normal after that, or you assume that chaos is just around the corner. On the basis of the first assumption, one would hold one’s breath and keep portfolios where they are. On the basis of the second assumption, one would reposition to protect against chaos. The problem with that is that full protection is expensive and will cost dearly in terms of opportunity losses if nothing bad happens in the end. We think that an eleventh-hour deal remains the most likely and believe that the sensible approach for investors is to stick to their guns and maintain positions. This seems to be what most investors are doing. Implied volatility on the S&P500, as measured by the VIX index, rose to 20% early last week, but settled down near 15% last Friday.

Economic data encouraging

Most economic data released last week was encouraging and we see no reason to reconsider our underlying views. Several Japanese indicators suggest that the economy is holding on to its momentum, if not strengthening it. Machine orders rose strongly in August and are now back over 10% up yoy. The tertiary industry index for August was stronger than expected and the so-called Eco Watchers survey strengthened materially in September after sliding since April. Bank lending growth stabilised at 2.3% yoy, which may not sound impressive, but is significantly above the average growth rate of recent years. Strong demand for housing appears to be behind this.

The most important data in Europe arguably concerned German orders and industrial production for August. The data was mixed as orders were soft and they disappointed, while production was strong and ahead of expectations. UK industrial production, on the other hand, fell short of expectations in August, dropping 1.2% mom, but this data can be volatile and the trend remains positive. In fact, the UK RICS housing survey is suggesting that the recovery of the housing market is gaining pace. The balance of surveyors reporting an increase in prices was the largest since 2002, and sales expectations for the next three months reached a new peak.

Obama nominates Janet Yellen

President Obama has nominated Fed vice-chair Janet Yellen to succeed Ben Bernanke at the end of January. Assuming she will be appointed, this implies a continuation of current policies. If Yellen differs from Bernanke, it is in that she is probably even more engaged with the non-conventional measures of monetary policy which the Fed has developed and applied in recent years. She is seen as an extreme dove. Earlier this year, in one of her remarks on communication she said that the Fed, under particular circumstances, might give more weight to its employment objective than to its inflation objective. People seem to forget that she added there might be circumstances when the opposite is true. Perhaps the Fed boss-designate is better described as pragmatic rather than dovish. In any event, markets took the announcement positively, and rightly so.