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Analysis: Investors wince but keep calm as U.S. budget battle looms

By Steven C. Johnson

NEW YORK (Reuters) - Another year, another battle over the U.S. budget. It's hardly what investors need, but it looks like they're going to get it just the same.

That doesn't mean it's time to panic. Last December's showdown over tax policy, while unpleasant, turned out to be just a minor speed bump for the U.S. stock market, which raced to record highs after Congress struck a last-minute deal on New Year's Day.

But with investors already nervous about the Federal Reserve's plan to start scaling back its stimulus program, another fiscal policy standoff could be more disruptive this time around.

In recent days, both Democrats and Republicans have been digging in their heels, setting up another possible nerve-wracking battle over the debt ceiling, which the Treasury expects to hit by November.

"Hearing Washington banter back and forth over this again was like a recurring bad dream," said Ron Florance, deputy chief investment officer at Wells Fargo Private Bank, which manages $170 billion in assets.

"We've already had the Federal Reserve adding volatility to markets, which, frankly, it should be doing at this point. Now we may see the legislative branch adding volatility, which it should not be doing," Florance said.

A similar drama over the debt ceiling in 2011 wore on for months, ultimately costing the United States its top triple-A credit rating and unleashing a global market rout.

Of course, much depends on how the economy performs in the second half of the year and what the Fed decides to do. If growth picks up steam and the Fed only modestly pulls back in its $85 billion-a-month buying of debt securities, as expected, then it might be easier to overlook Washington gridlock.

But if the economy stumbles, or if the Fed puts on the brakes harder and causes long-term interest rates to rise further and faster than expected, things could get dicey.

"We do think the economy is in much better shape today, so dysfunction in Washington will have less influence. But it will still have some influence," Florance said.

STOCK MARKET RISKS

The disagreement stems from a familiar ideological divide: President Barack Obama wants to boost investment in areas he argues would spur growth and top Democrats in Congress want to raise taxes, while Republicans want to cut spending and force the White House to scale back its signature healthcare program.

House Speaker John Boehner warned last week that Republicans would not vote to raise the government's legal borrowing limit without spending cuts.

Complicating things this time is an October 1 deadline for funding the government. While few expect Washington to actually shut down, the acrimony around budget talks could make it harder to strike a deal on the debt ceiling later in the fall.

Ironically, the immediate budget outlook has improved despite - or perhaps because of - Congress' pig-headedness.

The last-minute New Year's deal to avoid across-the-board tax hikes resulted in higher taxes on the very wealthy. And broad spending cuts designed to save more than $1 trillion over the next decade came into effect this year after lawmakers failed to agree on a more detailed and targeted package.

Coupled with swifter growth, this helped ease the threat of new ratings downgrades. The Congressional Budget Office now estimates the deficit, which exceeded $1 trillion for several years after the financial crisis, will drop to $378 billion by 2015, or just 2.1 percent of total output.

"They didn't do it the right way, but they got the right result," Florance said.

That said, the prospect of yet another last-minute deal doesn't mean investors can breathe easier. Brian Singer, a portfolio manager at William Blair & Co, which oversees $53 billion, said it's the public bickering and down-to-the-wire brinkmanship that's most disruptive and costly to investors.

The biggest loser may be U.S. stocks. Having soared to an all-time high and outperformed markets overseas, the benchmark S&P 500 is ripe for a correction, said Singer, who holds put options on the index that expire in late October, around the time the debt ceiling impasse may come to a head.

What's more, with Europe in recession, China slowing and Japan stuck in neutral, Singer said investors have come to see the United States "as the only source of growth and stability."

"If the budget debate leads to fears of instability and policy uncertainty, that could push equity markets down, and if investors think this is going to be problematic for U.S. growth, that would also cause equities to go down," he said.

Singer is long European equities and sees value in Spain and Italy, where he says economic conditions are stabilizing.

TEST FOR BOND MARKET

Treasuries, meanwhile, have sailed through recent budget battles unscathed. When the last debt ceiling showdown spurred Standard & Poor's to strip the United States of its top AAA rating in 2011, government borrowing costs actually fell.

But Thomas Graff, a portfolio manager at Brown Advisory in Baltimore, which manages $40 billion, said investors "should not take it for granted that the market will always be so forgiving."

For one thing, the global demand for bonds in general and U.S. Treasuries in particular has waned considerably. Between 2009 and 2012, when markets were reeling from crisis to crisis, global investors poured $1.1 trillion into U.S.-domiciled bond funds, data from fund tracker Lipper shows, by far the biggest inflow for any four-year period back to 1992.

But since Fed Chairman Ben Bernanke first suggested in May that the central bank could ease up on its monthly $85 billion bond purchases this fall and possibly end them next year, investors have yanked $49.3 billion out of bond funds.

That drove the benchmark 10-year yield to nearly 2.75 percent, almost a two-year high, and more than 100 basis points above where it stood at the start of May. The 10-year yield is currently at 2.58 percent.

"We haven't had this sort of political wrangling at a time when bond flows were drying up. Until now, there were always other buyers out there," Graff said. "Maybe this time around, they won't be there."

Gregory Whiteley, a portfolio manager at DoubleLine Capital, which manages $55 billion in assets, said investors should be prepared for more bond market volatility. But he added that Fed support will not disappear overnight and a still uncertain outlook for the economy will keep interest rates capped.

"Could the 10-year get back to 2.75 percent or even 3 percent between now and the end of the year? Sure, but that doesn't mean the next stop is 4 percent," he said.

In the meantime, properly prepared investors should look on the bright side.

"This could make things bumpy, but at the same time it will hopefully create some opportunities," Whiteley said. "It's been tough with no volatility these past few years to generate much incremental return, particularly in Treasuries."

(Additional reporting by Sam Forgione; Editing by Martin Howell and Ken Wills)

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