Wednesday, October 16, 2013

UPDATE: Washington Woes

  by Matt Malick and Ben Atwater

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.” Ernest Benn

“Politicians are like diapers.  They both need changing regularly and for the same reason.” Unknown

The continuing government shutdown and the impasse over the debt ceiling make this a stressful time for investors.  Particularly frustrating, as investment managers, is the impossibility of handicapping political martyrdom.

That said, our most likely scenario is that moderate Republicans will persuade Speaker Boehner to bring a “temporary” debt ceiling vote to the House floor.  Many believe that a majority exists in the House to pass such a measure today.  This legislation would likely be a stopgap measure to include a side agreement for future talks.  Over the last few days, Speaker Boehner’s camp seems to have delinked Obamacare from the debt ceiling debate, recognizing it is a political loser.  So future negotiations will probably be linked to entitlement reform and other spending reductions.

However, we believe that investors have been too sanguine about a resolution to this political drama.  There is no reason to think that President Obama and Speaker Boehner won’t go to the 11th hour.  We would not be surprised to see heightened market volatility next week.

From its September 18, 2013 closing high of 1725.52, the Standard and Poor’s 500 Index fell just 4.2% as of Wednesday’s close, before rallying aggressively Thursday and Friday.  From a contrarian perspective, we would frankly prefer to see the market a little more panicked at this point . . . In a way, the equity market seems to be giving Washington the benefit of the doubt.  Perhaps investors concur with Winston Churchill, who once said, “Americans can always be counted on to do the right thing . . . after they have exhausted all other possibilities.”

Maybe investors are also remembering that we have seen this movie before.  In July of 2011, Obama and Boehner brought us to the brink of default over failed debt ceiling negotiations, resulting in a drop of 20% in the S&P 500 and also in Standard & Poor’s downgrade of U.S. sovereign debt from AAA to AA.  When the smoke cleared, markets recovered quickly.

Another possible factor behind the market’s complacency is that the consequences of default are so unthinkable that it is difficult to contemplate such self-destruction by our leaders.  But investors may be a little too comfortable with this consensus view.  Politics has become a narcissistic profession and stubborn pride could lead to great harm.

That said, despite dangerous ideology and extreme arrogance, we are cautiously optimistic that sense will prevail over mutually assured destruction.

At the height of the last debt ceiling crisis on July 26, 2011, we wrote to you that:

“Our highest probability scenario is that the government will act “in time” to raise the debt limit (a peculiar necessity considering Congress made the expenditure and revenue decisions which created the structural debt to begin with).” 

The atmosphere in Washington seems even more poisonous now that it was then.  However, given the backdrop of a financial crisis, a completely dysfunctional government and a sluggish economy, some amount of good news over the next few years should fuel additional interest in capital markets.  But, such frequent self-induced crises are enough to dampen our enthusiasm.

That said, frustration aside, we see an ultimate resolution to the crisis du jour.  Now is not the time to make rash investment decisions.  Nothing fundamental has yet changed and as a result we still believe that patience will reward investors who stick to their discipline (as has always been the case).

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