4th October 2013
President Obama has issued a surprise warning to Wall Street over the political impasse currently causing a partial shut-down of government services in the US. Rather than issue the standard platitudes to reassure the market, he says that markets should be ‘genuinely concerned’. This may be political posturing on his part, but how concerned should investors be about the problem? Cherry Reynard reports.
First, it should be said that government shut-downs are nothing new. James Butterfill, global equity strategist at Coutts, says there have been 17 previous government closures, which have typically lasted seven days. His research suggests that these shut-downs do have an impact on markets, but it is usually short-lived: “Performance varied significantly depending on the length of the shutdown – for those lasting less than five days, shares actually gained an average of 3.3% over the 20 days after the shutdown, whereas they fell on average 2.9% over the 20-day period for shutdowns that lasted more than eight days.”
Equally, few see any economic impact from a short-lived government shut-down. David Hillier, senior US economist at Aviva Investors, says that his central growth forecast for the US economy remains unchanged at 2% to 2.25% between late 2013 and the end of 2014, with growth then picking up to around 2.75% in 2015, and asset prices should emerge ‘relatively unscathed’.
The worry is if the market starts to factor in a longer term economic impact from the failure to agree. Abi Oladimeji, head of investment strategy, Thomas Miller Investment, says: “From an economic standpoint, the impact of the government shutdown will depend on how long the shutdown lasts. Having grown at a year-on-year pace of 1.3% in the first quarter, US real GDP was recently reported to have grown at a slightly better year-on-year pace of 1.6% in the second quarter. While growth estimates remain subject to revisions, it is clear that the pace of growth remains anaemic. Clearly, an economy that continues to operate with a substantial output gap and still growing at a below-trend pace four years into an ‘economic expansion’ hardly needs another negative growth shock.”
In terms of economic impact, most experts believe that the debt ceiling negotiations are far more important than the current spat. Russ Koesterich, chief investment strategist for BlackRock, says that: “Ultimately, we believe Congress and the President will be able to come to an agreement to raise the debt ceiling, but if they fail to do so, it would have dire economic and financial market consequences. Investors should expect more volatility in the near term.”
And what if they can’t agree? Like Koesterich, Oladimeji says political miscalculation here could have ‘severe consequences’ for both the US economy and global financial markets. This article in Wall Street Journal highlights research by Scott Baker, Nicholas Bloom and Steven Davis, which found an increase in US policy uncertainty similar to the rise that occurred between 2006 and 2011 would reduce U.S. output by up to 2.3% over a year, cut private investment by 14% after three quarters and axe 1.5 million to 3 million jobs. With the Chinese economy not yet firing, this risks plunging the global economy back downwards.
This would not necessarily be bad for financial markets were US valuations not at already elevated levels, but Jason Hollands, managing director – business development and communications at Bestinvest says that corporate fundamentals do not necessarily favour US markets either: “US stocks simply look pricey, with earnings having arguably peaked. We are therefore in a period where US stocks are vulnerable to a correction.” Hollands adds that on the resolution of previous US government shutdowns markets have accelerated with the S&P 500 Index rising 11% on average in the 12-months following the 12 instances of government shutdowns since 1976, but this was at times when markets weren’t as highly valued.
To put this in context, the S&P 500 is currently trading on a p/e of 17.3x, and the US market as a whole at 18.7x. This is significantly higher than most other developed market – the UK is on 14.4x and Germany on 13.8x, for example. It is glaringly higher than any developing market – China is on 7.1x, the Hang Seng (which includes Chinese stocks) is on 10.6x, the Russia market is on 5.9x. This gives the US markets relatively little margin for error if corporate earnings growth does not go as planned or the debt ceiling negotiations go badly.
Many investors have already reached the conclusion that US equities are a weak spot. In the latest Morningstar fund flows report, US large cap growth equity was the least popular developed market equity asset class with outflows of €680m. At the very least, it argues for selectivity. Some areas have extremely high valuations, while others provide more room for manoeuvre. The political turmoil will probably be resolved, but investors cannot afford to ignore the possibility that it won’t.