What the Debt Deal Means for Investors
By Russ Koesterich
August 3, 2011
On Tuesday, after a long and contentious debate, the debt ceiling wasofficially raised hours before the deadline.
The deal itself — which contained a modest headline deficit reduction number, mostly unspecified savings and the formation of a committee to deal with the hard cost-cutting questions — was largely what I expected. As I predicted, the deal also left some major issues unresolved including long-term reform of the US tax system and entitlements.
Still, even if many of the hard questions are put off until later this year, the deal does remove a significant risk — the risk of a technical US default — from the market.
That said, while the deal is a step in the right direction, there are still some potential risks for the market related to it. First, there’s the chance that the deal did not go far enough and could ultimately help lead to an eventual downgrade of US debt. Given the $2.4 trillion-size of the budget deal, a credit downgrade by S&P remains a distinct possibility, though credit agencies Fitch and Moody’s both confirmed the federal government’s AAA rating Tuesday.
There’s also the risk that the cuts in the deal are too frontloaded to one or two years from now and will dampen an already fragile recovery. In fact, on Monday and Tuesday, US stocks traded lower despite news of the debt deal as investors digested three particularly awful US economic reports that confirmed the recovery is teetering.
On Friday, a new report showed gross domestic product rose a lower-than-expected 1.3% annual rate in the second quarter, dashing some market watchers’ hopes of a second-quarter recovery. Then, on Monday, the Institute for Supply Management’s factory index fell more than expected in July. Finally, on Tuesday, personal income for June also came in lower than expected.
Front-loaded cuts would put another burden on the already fragile US consumer. The US consumer currently gets about 20 cents on the dollar from disposable income via transfer payments from Washington. If the deal ends up slowing such payments, it would be a further headwind for the consumer.
To the extent the ongoing budget issues resulting from the deal negatively impact credit conditions, the prospects for economic growth and market momentum – the three factors that historically have driven market volatility – investors should also expect more market volatility than we saw during the first four months of the year. In addition, as fiscal uncertainty meets an already weak economy, investors should also expect a rerating of risky assets, i.e. lower valuations in the US as well as across global equities and assets.
So while the deal removes the risk of a US default, investors are still facing a struggling recovery, rising volatility and lingering sovereign debt problems in all of the major developed economies, including the US. As a result, I believe that investors should continue to remain defensive. My preferred defense plays aremega caps, telecom and healthcare.
Longer-term, to the extent the deal leads to a long-term solution to the nation’s fiscal problems, it is a good thing. As of today, however, such a solution is still not evident.
In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility.
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