Market impact of fiscal mess

by: Peter de Bruin

  •  As the effects on the economy are limited, markets tend to take shutdowns in their stride
  • Likewise, not raising the debt ceiling is seen as such a distant tail risk…
  • …that debt ceiling debates do not jolt markets too much
  • Meanwhile, the global manufacturing upturn continued in September

Financial markets tend to take shutdowns in their stride…

After having assessed the economic implications in these pages yesterday, we look in today’s daily how financial markets tend to react to a US government shutdown. Intuitively, as the effects of a shutdown on the economy tend to be limited, markets should not respond too much. And judging from the experience of the shutdowns in the 1995-1996 period and previously, this indeed seems to be the case. For instance, the S&P 500 continued its upward trend during the first government shutdown from 13 to 19 November 1995, while equities moved broadly sideways during the second shutdown in that year. Meanwhile, 10-Y yields moved broadly sideways.

…while debt ceiling debates do not jolt markets too much

However, some might argue that this time will be different as Washington is not facing one but two deadlines. Indeed, apart from the shutdown, Congress needs to deal with the debt ceiling before late October, or risk a default. Although this could potentially lead to more financial market unrest, in the run up to the debt ceiling increase in July 2011, financial markets tended to keep their nerve. Admittedly, towards the end of July 2011, when the debt crisis peaked, CDS spreads spiked, and consequently, equity markets gave up some of their gains. But generally the reaction of financial markets was relatively muted. For instance, gold prices continued their gradual upward trend, with investors merely seizing the debt ceiling issue as an extra buying opportunity, while Treasury yields moved only modestly lower. Notwithstanding some higher volatility, EUR/USD was in essence range bound, though the JPY strengthened on the back of safe haven flows.

Euro debt crisis was the real culprit

Still, financial markets took a turn for the worse after the debt ceiling hurdle was cleared. Although some commentators relate this to the US downgrade on the 5th of August 2011, we should not forget that the general macro-economic backdrop was soft, while around that time the eurozone debt crisis also threatened to spiral out of control, as investors worried about the sustainability of Spanish and Italian debt. Indeed, Spanish and Italian interest rates went through the roof, while equity markets sank.

Global manufacturing upturn continues

Meanwhile, the growth acceleration in the manufacturing sector continued in September, according to various purchasing managers surveys published around the world. The US ISM manufacturing index rose to 56.2 from 55.7 in August. The further rise in this indicator is really rather impressive given the sharp gains seen over the summer months. Indeed, the indicator stood at just 49 in May. In China, the official manufacturing PMI edged up marginally though that followed a significant rise in August to the highest level since April 2012. Of the other significant emerging markets, there were gains in the manufacturing PMI in India, Brazil, Turkey and Poland, while in Russia it was stable. Encouragingly, there were also significant rises in the PMI in South Korea and Taiwan, countries that tend to do well when world trade is on the up. The odd ones out in this rising trend were the UK and the eurozone, which saw slight declines in their PMIs, but that followed impressive gains in the previous month. Despite all the ups and downs in market sentiment related to tapering and more recently the fiscal deadlines, it looks like the global economy continues to improve. This is the clear message from the soft data, though we still need to see it confirmed in the hard data. In our view, this is just a matter of time. Once the dust of the fiscal deadlines settle, we think the health of the economy will be the key driver of financial markets.