The debt deal will raise the debt ceiling, will provide a set of spending cuts over the next ten years and will be enough to remove the spectre of a US debt default.
Even with the immediate risk of the debt ceiling issue likely fading for now, however, there remains a risk that one or more of the credit ratings agencies could downgrade the credit rating of the US. It is unclear whether any agreement on long-term debt issues will reverse the trend of debt growing faster than GDP – an issue on which the ratings agencies remain highly focused.
Increased volatility
Financial market volatility has increased as the debate has escalated, but at this point, it is very unclear how markets would react to any sort of credit downgrade. Investors loathe uncertainty and the fixation over the debate in Washington has been enough to disrupt markets. For politicians, however, ambiguity and last-minute compromise have become standard tools of the trade.
The circus in Washington has taken attention away from economic and earnings data. Last Friday’s GDP report showed that second quarter growth came in at a lower-than-expected 1.3% rate. Furthermore, first-quarter growth was revised downward sharply to 0.4% from an original reported rate of 1.9%.
While this report certainly confirms that the economy has slowed, there has also been some positive news. Initial unemployment claims fell in July to their lowest level in several months, suggesting that we should be seeing some labour market improvements.
Corporate earnings have also continued to show resilience. At this point, approximately two-thirds of companies have reported second-quarter earnings, and over 70% have delivered results that were ahead of expectations.
Focus on fundamentals
Over the past several months, stocks have been stuck in a fairly narrow trading range, with strong earnings pushing prices higher and macro risks and the growth slowdown acting as counterweights. Once the debt and deficit pictures become more clear and once investors are able to price in the effects of the final deals, markets may be able to again focus on fundamentals.
From an economic perspective, the US economy remains vulnerable, which is not a comfortable backdrop for risk assets, but we continue to believe that the probability of recession remains low and that economic data should improve in the coming months. To us, all of this suggests that the positive forces for the markets should win out, but for that to happen additional clarity is key.
