Investing After the Shutdown

Have you ever ridden out a severe storm, such as a hurricane? After extreme winds and torrential rains that seem to signal the end of the world, there comes a sudden calm. You think it’s over; you hope it’s over. But just as abruptly as it all ended, the winds and the rains start up again. You realize it was just the eye of the storm.

That’s where the U.S. economy is now – in the eye of a terrible and fierce political storm, as a deeply divided and disturbingly dysfunctional Congress battles itself over the budget.

Yes, an agreement between the Democrat-controlled Senate and Republican-controlled House of Representatives has finally been reached at the last minute, which President Obama signed just minutes after the midnight deadline, reopening the government after 16 days of closure. But enjoy this calm while you can, because it won’t last long.

Yesterday’s deal will fund the government’s operations for about four months. December 13^th has been set as the deadline for working out the long overdue government budget. If it fails to reach a budget agreement by then, the government will yet again run out of money on January 15^th and will have to shut down once more. If an agreement is still not forthcoming, the U.S. will hit its next borrowing limit on February 7^th, with all those doomsday scenarios that we have heard about coming back to spook the markets once more.

The toll on the economy and markets exacted by the current fiscal ordeal gives an idea of what to expect over the next few months. Just what has that toll been? And how can investors prepare for the second half of this fiscal storm?

A Hefty Price for Nothing

The holdout by a small but powerful minority in the House of Representatives was intended to gain several concessions, primarily tax postponements and cuts to the funding of certain Obamacare programs. In the end, though, almost none of those goals was achieved.

“It was an exercise in dysfunctional government,” Judd Gregg, a former New Hampshire Republican senator, derided to Bloomberg. “It was a loser position from the beginning because there was no way in divided government you’re ever going to repeal Obamacare.”

About the only thing that was accomplished during these past 16 days was a disruption to the investment markets and an interruption to the economic recovery:

• Some 800,000 federal government employees plus hundreds of thousands more from government contractor firms missed half a month’s salary.

• Government suppliers lost a major source of sales, such as Stanley Black and Decker (NYSE: SWK), whose stock plummeted 14.26% yesterday alone on a lower revision to its forward guidance due to “a slower margin rate recovery within the Security segment, weakening emerging markets and the impact of the U.S. government shutdown on organic growth,” the company explained in its press release obtained by Yahoo! Finance.

• Standard & Poor’s calculates the shutdown reduced Q4’s GDP by more than 25%, erasing some 0.6% from the 2.5% annual growth projected prior to the closure, an evaporation of some $24 billion of economic production.

• Volatility crept into equity markets two weeks before the shutdown began, taking the S&P 500 index off its run into all-time highs with a hit of 82 points, or some 4.7%, in just three weeks, followed immediately by a sharp rise since. The CBOE Volatility Index (VIX) spiked from 13 to 21 back to 15 over that same short period.

• U.S. 10-Year Treasury yields also plunged off of their two year highs at 3% down to 2.6%, while the U.S. Dollar Index (DXY) fell from 82.6 to as low as 79.7.

“Millions suffered,” New York Senator and Democrat Charles Schumer summarized to Bloomberg. “Millions didn’t get paychecks. The economy was dragged down and confidence and faith in United States credit and in the United States around the world was shaken.”

Even though a default on debt payments was averted, the close call so damaged the government’s credibility that Fitch Ratings will keeping the U.S. on its credit downgrade watch list even after its reopening, “citing the government’s inability to raise the debt ceiling in a timely manner,” Bloomberg reports.

The close call shows just how willing the warring factions of government are to take the nation to the edge of financial ruin just so they could claim to have won something. Such reckless gambling attitudes seem so deeply rooted that they are expected to resurface in a few months’ time.

“Whether it’s a battle win or a war win for the president we don’t know,” former congressional lobbyist, Patrick Griffin, assessed to Bloomberg. “The next battle will come soon.”

So how can investors prepare their portfolios for that next battle?

Expect Volatility

If ever there were a period for traders to shine, this would be it. Since May, we have been in a traders market, with recurring opportunities to buy low and sell high. Just hold on to your hats, because the stormy weather could be fierce.

Just as storms are often caused by the colliding of two air masses – a warm one lifting up and a cool one pushing down – so too was the turbulence in the markets today. Where we used to have just the warm Federal Reserve lifting markets up, we now have the cold and bitter air mass in Washington pushing markets down. These two forces are swirling up a storm.

We know the Federal Reserve has been contemplating reducing its monthly bond purchases for some time now. Yet given the interruption to the economic recovery caused by Congress recently, plus still high unemployment and mortgage rates and the recent nomination of a dovish Yellen to succeed the current Chairman Bernanke – we can expect the Fed to delay stimulus reductions.

For how long? In the absence of economic data during the government shutdown, a tapering announcing at the FOMC’s December meeting is unlikely. And given the second battle over the budget leading into January and February, tapering at the subsequent Fed meeting in late January is equally unlikely. This takes us to – I would venture to say – the meeting of March 18^th to 19^th at the earliest. We could thus expect continued stimulus from the Fed for the next five months at least, offering both the equity and bond markets some stable support against any severe correction.

Yet the continuing battle over the budget will likely create upside resistance to the markets, as will the government sequester – those across-the-board indiscriminate spending cuts across most government departments – which have increased as of this month to $109 billion for fiscal year 2014.

We should, therefore, expect some range-bound channels for the markets going forward, and we might take a cue from market behavior recently observed. Bonds should continue to hold strong, as investors flock to safety in the midst of uncertainty. Equities should be purchased on the dips, with a strong expectation of continued support from the Federal Reserve until the spring.

The U.S. dollar, however, could weaken until bond tapering actually begins, as it will be pressured by lingering budgetary uncertainty, continued monthly stimulus, and another flirtation with debt default in the new year.

This pressure on the USD could give gold a needed bounce up. Its recent dangerous dip toward the mid $1,200s raised the fear of it falling through its recent low of $1,180, which would have triggered numerous sell stops, possibly pushing it back down to its 2008 high of $1,035.

But that scenario seems to have been averted for the time being. The winter and spring are usually bullish for precious metals, with continued fighting in Washington and Fed stimulus all coming together to push gold to the $1,600 level from which it fell earlier this year.

Caution and Conservatism

As always in times of uncertainty, keep any margin use to a minimum, stick with large cap companies which ride out the storms better than small caps, and don’t be afraid to pick up some bond funds, which often pay attractive yields above 5%. Caution and conservatism will dictate market activity until the next battle over the budget is finally resolved.

Until then, expect the second battle to be fiercer than the first. Resentment is already being voiced. “This is a terrible deal,” vented Republican Senator Ted Cruz, as cited by CBS News.

House Speaker John Boehner effectively served notice that the House is not taking their first loss lightly and will regroup for a more powerful resistance the next time around:

“Our drive to stop the train wreck that is the president’s health care law will continue. We will rely on aggressive oversight that highlights the law’s massive flaws, and smart targeted strikes that split the legislative coalition the president has relied upon to force his health care law on the American people,” he promised, as quoted by CBS News.

The storm is merely pausing to muster up more power.

Joseph Cafariello

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