Record S&P Shows Investors Unfazed by U.S. Gridlock: Economy
Investors are no longer letting political uncertainties in Washington keep them from pouring money into U.S. stocks.
Lawmakers show no signs of agreeing on a federal budget for the 2014 fiscal year, which may trigger more automatic spending cuts in a matter of months. They face a Feb. 7 deadline for raising the nation’s borrowing limit. And questions remain about how the Affordable Care Act will affect what Americans pay for health care. Even so, the Standard & Poor’s 500 Index climbed to a record last week and is up 25.6 percent so far in 2013.
“There’s this sense that every time we get to the brink, we’ll get over the brink without causing any damage,” said Diane Swonk, chief economist for Mesirow Financial Inc. in Chicago, which oversees $81.2 billion in assets. Lawmakers’ repeated last-minute deals have left investors “somewhat numb and not really all that sensitive to issues on Capitol Hill.”
The disconnect can be measured by comparing the ups and downs in the stock market with an index (SPX) of policy uncertainty developed by economists at Stanford University and the University of Chicago. Stocks no longer track the economists’ index as closely as they did before the recession ended in June 2009.
The Economic Policy Uncertainty Index, the work of Chicago’s Steven J. Davis and Stanford’s Nick Bloom and Scott Baker, tracks newspaper articles, federal tax provisions and the amount of variation in growth forecasts among economists surveyed by the Federal Reserve Bank of Philadelphia.
The correlation between the uncertainty index and year-over-year changes in stock prices shrank to 0.22 in the period from the end of the recession through October, from 0.43 for the period from January 1985 through June 2009, according to data compiled by Bloomberg. A correlation of 1 shows two groups move exactly in tandem, while zero indicates no relationship.
The newspaper gauge is updated monthly and looks for stories containing combinations of words such as “uncertainty,” “economy” and “regulation.” Considering only this gauge, the correlation drops to zero in the post-recession era from 0.49 over the previous 24 years, indicating stocks have completely uncoupled from policy ambiguity.
Since the recession ended in June 2009, equity investors have followed what game theorists call a “trembling-hand equilibrium,” where market participants believe the consequences of not reaching a deal are so dire that lawmakers will act rationally, said Michael Gapen, a senior U.S. economist at Barclays Plc in New York.
Gapen said “markets had confidence in the incentive structure that was in place” during October negotiations that produced an agreement to end the government shutdown and a suspension of the federal debt limit to prevent a default.
So far, the economy shows few signs of being damaged by Washington’s brinkmanship. Gross domestic product climbed more than projected in the third quarter heading into the budget impasse, and the 204,000 gain in October payrolls surpassed all forecasts of economists surveyed by Bloomberg.
“It feels like the economy is growing, albeit not great, but we’re moving forward despite the best efforts of our elected officials to hold us back,” said Walter Todd, chief investment officer at Greenwood Capital Associates LLC in Greenwood, South Carolina, who helps manage $950 million.
Todd said he believes lawmakers will reach agreement on a “smaller-scale” deal to get the U.S. past the next budget hurdles. “It still doesn’t address the structural issues, and that is a longer-term concern, but as far as the next several months go, I think we get through that relatively OK.”
The next test of market resiliency in the face of political turmoil is weeks away. Congress’s self-imposed deadline to agree on a fiscal 2014 budget is Dec. 13. The law now funding the government expires Jan. 15, and failure to reach agreement would mean more across-the-board spending cuts under sequestration. Finally, the suspension of the debt ceiling expires Feb. 7.
Stock market performance shows how investors have become desensitized to heated political debates. In the two weeks ended Oct. 17, when Obama signed the latest budget deal, the S&P 500 Index climbed 3.2 percent. That contrasts with a 16.3 percent decline in the two weeks ended Aug. 8, 2011, which included an agreement to avoid a default on the debt and a subsequent downgrade in the U.S. credit rating by S&P.
In today’s trading, the S&P 500 Index fell 0.2 percent to 1787.87 as of 4:21 p.m. in New York.
The Federal Reserve’s unprecedented monetary support is a major reason the market reaction was different this time around, said Greg Valliere, chief political strategist at Potomac Research Group in Washington.
“The biggest difference was the clear expectation of the Federal Reserve making up the difference, becoming even more accommodating,” said Valliere.
In August 2011, the Fed pledged for the first time to keep its benchmark interest rate at a record low, at least through the middle of 2013, in a bid to boost the recovery. Now, the Fed pledges to retain that policy at least as long as unemployment remains above 6.5 percent, and has added an open-ended commitment to continue monthly asset purchases to support the economy until the job market has improved “substantially.”
“Supporting the recovery today is the surest path to returning to a more normal approach to monetary policy,” Fed Vice Chairman Janet Yellen, the nominee to succeed Chairman Ben S. Bernanke, said during a confirmation hearing last week. “I believe the Federal Reserve has made significant progress toward its goals, but has more work to do.”
The Fed has maintained $85 billion in monthly asset purchases, ballooning its balance sheet to a record $3.91 trillion as of Nov. 13. Since 2009, the increase in the Fed’s holdings of Treasuries and agency mortgage-based securities has had a 0.94 correlation with movement of the S&P 500 Index, according to research by economists at Bank of America Corp. in New York.
Investors aren’t the only ones becoming more accustomed to political brinkmanship. The Institute for Supply Management’s manufacturing index rose in October to a more than two-year high, the Tempe, Arizona-based group’s report showed Nov. 1.
“Manufacturing and everybody else has really come to understand how Washington has been operating over the past couple years, and we try to look by that, assuming things are going to get resolved at some point,” said Bradley Holcomb, chairman of the supply management group’s factory committee.
While Wall Street looks toward 11th-hour resolutions, some consultants in Washington warn the latest round of negotiations had greater probability of triggering a larger crisis than in the past.
“While the market has a lot of faith that leadership will ride to the rescue, that’s nothing that they should bank on,” said Tony Fratto, managing partner at Hamilton Place Strategies LLC, a Washington-based consulting firm for financial companies, referring to lawmakers in Congress.
Fratto, a former Treasury and White House official in the George W. Bush administration, said investors shouldn’t count on Senate Republican leader Mitch McConnell to once again intervene to sway colleagues in the House. McConnell, of Kentucky, helped engineer a bipartisan resolution to avoid a debt default while a group of House lawmakers insisted on maintaining the government shutdown until the Affordable Care Act could be dismantled.
Republican Congressmen “do not believe that their strategy is damaging and dangerous -- they just believe it’s the normal way of doing business,” said Fratto. “That’s why I say it’s a much more dangerous period than people really understand.”
Consumers have been more concerned than investors. Twenty-six percent of respondents cited the inability of lawmakers to solve problems as the most pressing issue for Congress to consider, outweighing the combined responses for the economy and jobs, according to a George Washington University Battleground Poll conducted Oct. 27-31. Congress’s approval rating sank to 9 percent in a survey conducted Nov. 7-10, the lowest in the 39 years Gallup has asked the question.
The pessimism about Washington may translate into a subdued outlook for consumer spending as the U.S. enters the holiday shopping season. Household purchases, which make up almost 70 percent of the economy, climbed in the third quarter at the slowest pace in two years.
Rising stock prices, in turn, may mean lawmakers are under less pressure to adopt budget discipline, said Potomac Research Group’s Valliere. Congress has little incentive to reach a comprehensive deficit-reduction plan such as the Simpson-Bowles proposals drafted in 2011 without an “angry market,” he said.
“That probably is a negative in terms of pushing Washington into doing the right thing, because you don’t have that catalyst,” said Valliere.