The Fiscal Standoff is Sneaking Up on Wall Street

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Published September 27, 2013

| FOXBusiness

Up until late this week, U.S. investors appeared largely unfazed by the threat of a government shutdown and the more ominous specter of a debt-ceiling disaster.

But don’t let the delayed reaction fool you. The same could have been said just before the near-default by the U.S. in the summer of 2011 as Congress and the White House botched the handling of the debt ceiling. But within just weeks, the S&P 500 had tumbled nearly 8% and the VIX volatility index spiked 54%.

That episode reveals how early ambivalence about fiscal standoffs can be quickly turned on its head with indiscriminate carnage across a broad spectrum of global asset classes.

“Financial markets have tended to react slowly to political developments,” Barclays (BCS) wrote in a note this week. “The last-minute market reaction to brinksmanship dynamics makes logical sense, but it highlights the risk that the so-far muted response to the latest developments in Washington could rapidly be reversed.”

With that thinking in mind, the Dow Industrials shed as much as 116 points on Friday, although  the index is sitting just 3% away from all-time highs.

Clock Ticks on Shutdown

Unless a deal is reached in the coming days, the federal government is set to shut down on October 1 for the first time since 1995-96.

While a government shutdown would surely reinforce concerns about political dysfunction in Washington, a short-term episode would be unlikely to seriously damage stocks.

That’s because Barclays estimates that for each week of a shutdown, real federal government consumption and gross investment would drop 1.6% quarter-over-year and real GDP growth would dip only 0.1 percentage point.

The four-week shutdown in the mid-1990s cut U.S. GDP growth by 0.5 percentage points, the Congressional Budget Office estimates.

“A short federal government shutdown is unlikely to dampen real GDP growth significantly and adverse market reactions are more likely to be short-lived,” Barclays director of U.S. economic research Michael Gapen and emerging markets strategy head Michael Gavin wrote in a report.

The S&P 500 dropped 3.7% from peak to trough during the ’95-’96 shutdown, only to bounce back 10.5% in the subsequent month, according to S&P Capital IQ.

The conventional wisdom in Washington is betting a last-minute deal will be reached, averting a shutdown. But the consensus also erroneously called for a September taper from the Federal Reserve -- and we know how that turned out.

“With a mid-term election year right around the corner, it may behoove one party to allow the unthinkable to occur, so long as the other party got the blame,” Sam Stovall, chief investment strategist at Capital IQ, wrote in a recent report.

Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at KeyCorp.’s (KEY) Key Private Bank, said, “If we roll over the edge and everything shuts down, that could have a major effect on the market.”

Even if the government does shut down next week, the brief trip over the fiscal cliff at the end of 2012 suggests damage to stocks could be limited. The S&P 500 dipped just 1% between the first half of December and the end of the year, although the VIX soared almost 39% over that period.

Contemplating the Unthinkable

The far bigger risk for Wall Street and global investors is a catastrophe surrounding the $16.7 trillion debt ceiling.

The Treasury Department said it will exhaust its borrowing ability on October 17, setting up a potential disastrous and once-unthinkable default on U.S. debt -- which is supposed to be the safest asset out there.

“We’ve seen this play before. Yes, they posture right down to the end, but they usually come around to do what they have to do,” said McCain. “If we actually got to the point where we couldn’t pay the bills, that would really unnerve people.”

That rationale helps explain why thus far, concerns about the debt ceiling among equity investors appeared to be relatively muted.

Yet that indifference isn’t replicated in the credit-default swap market. According to Markit, the cost to insure $10 million of U.S. debt for one year spiked to 31,000 euros this week, up dramatically from just 5,000 euros as recently as last Friday. It’s also the highest level since the unprecedented downgrade of     U.S. debt by Standard & Poor’s in 2011.

“The debt ceiling crisis will become very real very soon -- a genuine headwind for the economy as investors and businesses and consumers get a bad case of the jitters,” Greg Valliere, chief political strategist at Potomac Research Group, wrote in a note to clients this week.

According to Barclays, the S&P 500 suffered a 7.6% dive between the July 14, 2011 when S&P warned of a possible downgrade and September 15 of that year, while the yield on the 10-year Treasury slid 8.4% to 2.08% and the VIX surged 53.7%.

Interestingly, the bleeding wasn’t contained to U.S. assets: the Euro Stoxx 50 plummeted 20% and the Nikkei 225 shed 12.8% over that span.

“The limited historical evidence suggests that anxiety about a U.S. credit event would be a global risk event and that positioning for global risk-off would be more productive than positioning for relative weakness of U.S. risk assets,” Gapen and Gavin wrote.  

‘Avoid Getting Thrown Off’

Of course, the U.S. narrowly avoided a default that the White House and many outside observers warned would have been catastrophic.

Risk assets bounced back accordingly. Since sinking to 1209 in mid-September 2011, the S&P 500 has surged 43% through last week’s all-time high of 1729.86.

Could the same thing happen this fall?

“It’s been my long-held view that the trick to the bull market since March 2009 is to stay on the beast and avoid getting thrown off,” Ed Yardeni, president of investment advisory Yardeni Research, told clients this week.

“An October correction triggered by a fiscal fiasco in Washington is still possible,” he said, but “that might very well set the stage for a yearend rally.”

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