Government shuts down, stocks go up. What’s the story?

October 8, 2013 Categories: Portfolio Corner
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Government shutdown

The best economists, including ours, can explain why a government shutdown could be greeted by the equity markets as a non-event, as it indeed was on October 1st.1 Here’s a link to their analysis.

But, there’s more to this story than economics. Let’s consider the possible state of mind of the typical individual investor: many Americans have arrived at crisis fatigue, tired of the endless line of boys crying wolf, and deeply suspicious of the “facts” trotted out to prop up an apparently endless buffet of apocalypse arguments. A partial list includes: predictions of double dip recession, predictions of Euro collapse, catastrophic implications for the integrity of the Greenback from “printing money” – aka Quantitative easing (QE). (In fact, we might need to create a whole category of QE-related catastrophes-in-waiting: runaway inflation or deflation, depending on the week; catastrophic distortions of asset values from QE… you get the picture.)

With so many voices crying fire, the typical person may have come to demand to see the flame, if not pass his own hand through it before he or she will once again believe. Should this current government shutdown amount to little more than a theatrical spark that never catches fire, then seeing stocks go up the day the government shuts down would be a rational result. But what if it is not just a short-lived stunt? At what stage should we start to be concerned that where there’s smoke, there’s fire? Is it simply a matter of time – the longer it goes, the worse it will be? Or is it a matter of gravity — maybe nobody cares about a theatrical shut down for a few days, but the operational questions of the debt ceiling are less easily deflected. And then of course, there is the “mother of all issues”: could this actually lead us to a default on U.S. debt?

Maybe some of you remember our advice to you regarding the euro crisis? Basically, our argument was that it would ultimately be resolved – even if that process was not completely orderly – because we believed the costs of a euro break up were both bigger and more unpredictable to the one party with the most to lose (Germany) than the costs of a resolution. This is exactly what is unfolding in Europe now. I believe the same argument could be applied to the U.S. now: the extent of the costs and disorder that would be catalyzed by a U.S. debt default are equally enormous, and could lead to side effects that are no less poisonous.

This morning the “Bond King” Bill Gross reported in a Bloomberg interview that he’s placing the odds of a debt default at a million to one. While that makes sense from an economic lens, remember that if nobody ever made million-to-one bets, there would be no such thing as a lottery ticket! At Russell, we’re concerned about the mixed signals you’re receiving – the hysterical arguments to which the participants bring their own private set of “facts.” Instead, help your clients to stay focused on the following:

Number One: We believe the U.S. economy is in better shape than the U.S. government. The U.S. Business Cycle is firmly back on track.

Number Two: Don’t believe everything you read about “Tapering.” Tapering is good news for the economy (even if it wobbles the markets a bit in the short term) because it means that the economy is strong enough to function on its own without the Federal Reserve propping it up.

Number Three:  Don’t believe everything you hear about bonds being a dumb investment now that interest rates will “certainly spike.” Our analysis is that U.S. interest rates are on a slow and steady path to normalization. So while bond returns might not look as heady as they have in the recent past (say about 5% for the last five years based on the Barclays U.S. Aggregate Bond Index as of September 30, 2013), they’re unlikely to be 0%, either! Russell’s forecasting team is expecting about 3-4 % over the next 10 years. So if your options on bonds amount to Bail out, Bail in or Calm Down, we’d suggest going with Calm down!

Number Four: The European Central Bank and the Bank of Japan have both followed suit with the Fed. Why should we think that their monetary policy actions will be any less effective in stabilizing their economies and creating a positive lift for stock prices? With Europe finally and irrefutably coming out of its doldrums, we like our emphasis on investing globally in general, and in Europe and Japan in particular, better than ever.

The bottom line

Investors have received a lot of mixed signals about the state of global markets, economies and governments. For many, this has led to crisis fatigue and an uncertainty about where to focus, when to be alarmed, and when to simply shut out the noise. Guide clients by bringing their attention to some of Russell’s current views of the markets and economies.

1 The Russell 3000® Index had a 1-day return of 0.92% on October 1, 2013.

Russell 3000® Index: Measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Created by Russell’s Chief economist for North America, Mike Dueker, the Business Cycle Index (BCI) forecasts the strength of economic expansion or recession in the coming months, along with forecasts for other prominent economic measures. “Dynamic forecasts of qualitative variables: A Qual VAR model of U.S. recessions”, published in the Journal of Business and Economic Statistics in January 2005, provides background on the statistical model behind the BCI.

Russell’s Capital Market forecast assumptions do not take fees into consideration and all returns are assumed gross of fees. Please note all information shown is based on assumptions. Expected returns employ proprietary projections of the returns of each asset class. We estimate the performance of an asset class or strategy by analyzing current economic and market conditions and historical market trends. It is likely that actual returns will vary considerably from these assumptions, even for a number of years. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve. Asset classes are broad general categories which may or may not correspond well to specific products. Additional information regarding Russell’s basis for these assumptions is available upon request. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

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