Washington Strikes a No-Surprise Deal – Now What?

Wardwell’s Weekly Market Report
Observations on the Capital Markets – Week Ended October 18, 2013

  • Washington watch: a no-surprise deal kicked the can down the road
  • Markets celebrated – and more QE likely…
  • Meanwhile, 16 days of government ‘closure’ had little impact on GDP
  • China voiced its currency concerns – loudly
  • Global economic news was generally more upbeat than U.S. news
  • Fed watching . . . and waiting

Washington Watch: A No-Surprise Deal Kicked the Can Down the Road
Congress called a time-out in the budget/debt fight last week, striking a deal to avoid default and fund the U.S. government through January 15, 2014 and raise the debt limit through February 7, 2014. While the parties agreed to budget talks, they did not commit to reaching an agreement (technically, Paul Ryan and Patty Murray, the House and Senate budget committee chairs will begin a process of fiscal negotiations, due to wrap up by mid-December).

Captain Obvious alert: Fitch announced that it is putting the U.S. government’s AAA credit rating under review and China’s top rating agency, Dagong, downgraded U.S. Treasuries.

Markets Celebrated – and More QE Likely …
Both bond and equity markets rallied last week as. The agreement was really just a deadline extension, not an agreement on anything substantive. Speculation that a Yellen-led Fed would defer quantitative easing (QE) tapering for “risk management” reasons, given the ongoing fiscal uncertainty, drove down bond yields and the U.S. dollar (USD).

  • Currencies: The USD dropped about 1% against the Euro and Yen when the budget deal was announced on Thursday (the market expects more QE). For the week, the Euro was up about 1% against the USD and half as much against the Yen. The emerging market (EM) currencies I’m watching, generally ticked up last week and seem to be stabilizing at levels 5-15% below where they were at the end of April.
  • Bonds: The 10-year Treasury yield fell 10 basis points (bps) to 2.60%; the 10-year TIP yield fell 8bps to 0.42%. Key indices returned 0.6-0.9% with credit outperforming as the BoAML High Yield Index fell 16bps to 446. Foreign sovereign markets were generally quiet.
  • T-Bills: The 1-month T-bill yield rose from 0.04% to 0.32% in the run-up to the debt ceiling deal (Rule 2a7 prohibits money market funds from owning defaulted paper); the bill closed the week back down at 0.04%.
  • Equities: The Standard & Poor’s 500 Index (S&P 500) was up almost 2.5% for the week. The MSCI Europe Index was up about 2%, MSCI EM was up just over 1% and MSCI Japan just under 1%. Within the S&P 500, strong earnings from Verizon helped Telecom Services (+3.2%) lead; Financials were also relatively strong, while Utilities (+2.4%) lagged. IT sector earnings spotlighted Google, which was up 16%, and IBM down almost 7%.
  • Commodities: Gold rose 3% on Thursday and ended the week up 4%. WTI oil was down about 1%.

Meanwhile, 16 Days of Government ‘Closure’ Had Little Impact on GDP
The U.S. government was “closed” for 16 days, but federal spending didn’t drop enough to impact GDP. Government purchases may have been delayed, but no spending was cancelled – “mandatory” spending (e.g. interest, entitlements) continued unabated. Furloughed employees will be paid for the days they didn’t work (70k filed for unemployment compensation). Estimated 15k private sector workers were laid off because of the government shutdown. They, the would-be visitors to national parks and the businesses (e.g. restaurants and hotels) that serve them probably suffered the biggest losses.

China Voiced its Currency Concerns – Loudly
China’s official news agency published a piece very critical of the Washington circus. It called, in essence, for a de-Americanization of the global economy and a new global reserve currency to replace the dollar – a full-out rant.

Background: For years, the Chinese have held down the value of their currency to support export-led economic growth. By doing so, they have accumulated huge foreign exchange (FX) reserves, largely invested in U.S. Treasuries. Their currency remains under upward pressure. QE-fueled weakening of the USD exacerbates that pressure, costing them money; the possibility of a default concerns them. It’s understandable that they’re upset.

Comment: As the old banker put it: “If I owe you a thousand, I have a problem; if I owe you a million, you have a problem.” China has a problem.

U.S. Economic Data Wasn’t Really Upbeat

  • The Fed “Beige Book” characterized economic growth as only “modest to moderate.”
  • The NY (Empire) and Philadelphia Fed regional surveys were soft.
  • The NAHB Homebuilders index ticked down.
  • Mortgage applications declined again (maybe just shutdown noise) but…
  • Daily consumer confidence measures were down sharply just before the DC deal … affecting retail.
  • After a soft start, earning season is looking somewhat better … but it’s really just OK so far.
  • Higher initial unemployment claims (358k) were distorted by one-off factors. There was more catch-up from the California systems change-over.

Global Economic News Was Generally More Upbeat

  • China’s Q3 GDP was up 7.8% year over year (y/y). Other Chinese data (e.g. weaker exports, somewhat elevated CPI) were weaker…but on balance, it’s still looking more like a soft landing than a hard landing.
  • The number of people employed in the UK hit an all-time high; UK retail sales were strong.
  • The Eurozone trade surplus rose on export growth, notably from Portugal, Greece and Ireland.
  • September new car sales in Europe were up 5.5% y/y.
  • The German ZEW business confidence index came in better than expected.
  • Angela Merkel’s Christian Democratic party is struggling to attract a partner to form a coalition government: potential partners understand they’ll face attacks from the left in the next election, so are very demanding.

Fed Watching . . . and Waiting
The Fed is data-dependent, and their QE tapering timeline is dependent on the pace of the economy’s improvement. Their September decision to hold off on tapering reflected, in part, their lack of confidence in the economy’s strength. The Congressional follies are leading many to believe the start of tapering will be further delayed.

The next Fed meetings are October 29-30 and December 18-19.

Data Sources: The Wall Street Journal, Financial Times, Bloomberg.

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