President Trump has made it clear that if the Congress doesn’t give him the money to build his pet project – a wall along the border – he will not sign any bills. If this impasse is not sorted out by September 30, it will end up in double chaos.
- We have a stalemate between the Congress and the US President
- Stock market’s performance has been mixed during debt ceiling crisis and government shutdown
- The debt ceiling crisis in 2011 was followed by a credit rating cut, which led to a huge correction in the equity markets
- Goldman Sachs sees only a 35% probability of a government shutdown
- We believe that the equity markets will not remain sanguine if an agreement is not reached in time
The US economy will have to face the consequences of a government shutdown and fears of some kind of default for failing to raise the debt ceiling on time. Let’s see how these events have influenced the stock market in the past and will history repeat itself this time?
What is a government shutdown and a debt ceiling?
In simple terms, debt ceiling is the limit on the amount of debt that the US Treasury can issue for financing various government expenditures. If the debt ceiling is not raised in time, the US Treasury has to resort to “extraordinary measures” to fund government expenses. However, if the situation drags longer, it can even lead to a default, a catastrophic event for the economy and the equity markets.
The United States Constitution has empowered the United States Congress to appropriate funds for government operations. The appropriations bill is first passed in the House of Representatives and then by the Senate after which it is sent to the President who either signs the bill or ignores it. Under both conditions the bill becomes law.
However, if the President vetoes the bill, it is then sent back to the Congress, which can override it with a two-thirds vote. Nonetheless, if both the Congress and the President fail to sort out the logjam, the government will have to shutdown non-essential operations and obligations for paucity of funds, sending thousands of federal employees on furlough.
How many times has this happened in the past?
US Government shutdown
Most of the government shutdowns prior to 1980 were confined to the political circles because the federal employees continued to work and were paid retrospectively when an agreement was reached. However, in 1980 and 1981, the then-attorney general Benjamin Civiletti gave his legal opinion that the government work has to stop until Congress agrees to fund it.
Since then, there have been 12 shutdowns. The longest was from 15 December 1995 to 06 January 1996 that lasted 21 days. The last shutdown was in 2013, from September 30 to October 17, lasting 16 days during President Obama’s tenure.
Debt ceiling crisis
The Wikipedia has listed 87 instances of debt ceiling changes since 25 June 1940. On most occasions, there was no major damage to the economy, however, the 1995 debt ceiling crisis led to the longest government shutdown in the US history.
The crisis in 2011, though resolved at the 11th hour, led to a credit rating downgrade of the US for the first time by the credit-rating agency Standard & Poor’s from AAA to AA+. Similarly, during the debt ceiling crisis in 2013, credit rating agency Fitch Ratings placed the US under a “Rating watch negative”.
How did the various markets respond during the previous two debt ceiling crisis?
Source: Seeking Alpha
Leading to the previous two debt ceiling crisis, the stock markets fell in 2011 but rose is 2013. On the other hand, the US dollar fell marginally, whereas, the Treasuries rallied during both occasions.
However, that is only half the story because, in 2011, the markets fell sharply after the debt ceiling crisis ended because of the S&P credit rating cut. However, in 2013, the markets continued their journey northwards even after the crisis ended.
Similarly, during government shutdowns, the equity markets have been mixed. Nevertheless, on an average, they have fallen 0.6% over the period of the closure, according to LPL Financial.
Source: Market Watch
This shows that the government shutdowns have not materially affected the stock markets. So, will the current deadlock also be uneventful for the equity markets?
What is likely to happen this time?
The economic situation and the political backdrop during every shutdown or a debt ceiling crisis is different. Let’s see some expert opinions this time.
Goldman Sachs, which two weeks back had given a 50% chance of a government shutdown has reduced it to 35%, following the catastrophic storm Hurricane Harvey. Goldman believes that no political party will want to own the blame of obstructing federal relief works underway, hence, the change in forecast.
Analysts at Morgan Stanley, however, are of the opinion that a solution will neither be easy nor smooth. According to them, a sharp fall in the markets may be needed to pressurize both sides to arrive at a compromise.
Isaac Boltansky, director of policy research at Compass Point Research & Trading in Washington said, “I think this time will be worse because of the uncertainty from President Trump,” reports The New York Times.
However, a few others maintain that both the issues will turn out to be a non-event for the stock market. Most shutdowns “don’t last long and equities rarely see a large sell-off,” wrote Ryan Detrick, senior market strategist at LPL Financial in a report on Thursday, reports CNBC.
We expect the markets to fall this time if timely action is not taken
The stock markets have risen sharply since the US Presidential elections of last year on hopes of tax reforms and higher fiscal spending. Also, both the bull market and the economic recovery cycle are on its last legs and a dip is likely, if history is any guide. However, as the bull market progresses, the market participants become complacent. This time too many believe that a compromise will be reached in time.
However, if the President and the Congress fail to arrive at a compromise in time, traders will start to question the possibility of any meaningful tax reforms going through. This will lead to a dent in confidence, which is likely to lead to a sharp fall.
On the other hand, if the political parties show a united front and find a middle path, it will be a morale booster and the equity markets are likely to rally to new lifetime highs.
Therefore, the current gridlock will move the markets one way or the other.
Tax Cuts and the US Stock Markets
The stock markets rise or fall on sentiment, earnings, and economic data. While the initial boost following the US Presidential elections was sentiment driven, the markets held their own as the data flow stabilized and improved in the US and around the world. However, at the current levels, the US stock markets look pricey compared to historical averages.
- The markets are trading at rich valuations even after discounting a favorable tax cut
- Treasury Secretary Steven Mnuchin believes market will crash without a tax reform
- A few analysts believe that the markets will remain firm even without a tax cut
- We believe markets will be vulnerable for corrections if Republicans fail to pass the tax cuts
- Buy the rumor regarding tax cuts and sell once the news of a tax reform is announced
Nevertheless, the hopes of a tax reform have kept the markets buoyed. How much can these tax cuts add to the markets and what is the risk if the reforms are watered down or just don’t see the light of the day?
Analysts expectations for the S&P 500
The S&P 500 is expected to end 2017 with earnings of $131 per share, increasing about 10% over 2016. For 2018, analysts expect the S&P 500 companies to collectively earn $145.2 per share.
However, there are differing views on whether these figures include the benefits accrued from the tax cuts or not. If the tax benefits are incorporated, then to what extent.
The most bullish analyst on the street, Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, believes that about $9 of $145.2 in the earnings projection is based on the benefits arising out of a tax cut. On the other hand, the most bearish analyst, Weeden & Co.’s Mike Purves, believes that $14 per share is from the tax cuts.
Let’s take a bullish scenario.
Analysts expect the annual per-share earnings to increase by $15 if the corporate taxes are cut from 35% to 20%.
However, Wilson has only accounted for $9 in benefits from the tax cuts. Therefore, we will have to add another $6, which gives us a figure of $151.2.
So, in the most bullish scenario, at 2580, the S&P 500 is trading at a forward p/e of 17 times.
Factset data shows that the 5-year average and 10-year average forward earnings P/E ratio of the S&P 500 is 15.6 and 14.1 respectively. Therefore, even with the most optimistic scenario of earnings built in, the S&P 500 is currently trading above its past averages.
However, just because its current valuations are above the historical averages will not cause a correction in the markets. But, can a failure to pass the tax cuts start a fall?
What if the tax cuts don’t see the light of the day or are diluted in their effect
Again, we shall consider the most bullish scenario. If the Republicans fail to pass the tax reforms, then the earnings projection for next year will fall by $9, to $136.2. At that level of earnings, the S&P 500 is currently trading at a P/E of $18.9, which starts to look pricey.
What level was the S&P 500 trading prior to the two previous crashes of 2000 and 2007?
As seen in the chart sourced from yardeni.com, the S&P 500 is already trading at a higher forward P/E than 2007. This confirms that we don’t have the comfort of valuations behind us. However, we are still a distance away from entering into a bubble territory when compared with the forward P/E of 24, recorded during the heights of the dotcom bubble. Therefore, a crash might not be in the offing.
How much will the S&P fall if the tax reforms don’t go through
Here again, there are two schools of thoughts. While one says that a failure to ring in the tax reforms can easily plunge the S&P 500, others believe that the stock market is unlikely to fall more than 5%.
Treasury Secretary Steven Mnuchin believes that a lot is riding on the tax reforms. In a podcast with Politico he said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done, you’re going to see a reversal of a significant amount of these gains.”
However, Credit Suisse and Morgan Stanley differ, as they don’t see a market crash even if the tax reforms fail.
“The market rewarded firms with high effective tax rates for only three weeks post-election, but not since,” wrote Jonathan Golub, Credit Suisse’s chief U.S. equity strategist. “For that reason, we do not believe that stocks would be at risk if a deal isn’t struck,” reports CNBC.
In a note to its clients, Morgan Stanley has painted three different scenarios with no tax cuts, modest cuts, and substantial cuts.
Morgan Stanley believes that the markets will only fall by 1% if the tax cuts don’t happen.
What do we believe?
We believe that the US market rally in the past year has been driven by hopes of a fiscal boost and tax reforms. These have kept the sentiment positive. As a result, the markets have risen on favorable economic data in the US and around the world and has not given up ground even when the news was unfavorable.
However, after failing to repeal Obamacare, if the Republicans fail to push through a meaningful tax stimulus, the sentiment will be dented.
That will leave the markets vulnerable to sharp drops on any adverse news because the floor of the reforms and an earnings increase will be lost.
On the other hand, if the tax reforms are announced, the markets are certainly likely to surge in the short-term, however, the bump up is unlikely to last for more than a few weeks. Usually, experienced traders buy the rumor and sell the news. We expect the same to repeat once the reforms are announced.
The markets will correct and the focus will shift to the effects of the stimulus at this stage of the recovery, which has been questioned by many economists. The Federal Reserve may also have to tighten at a faster pace than expected, which may neutralize some of the effects of the rate cuts.
Bottom line – To buy or to sell?
Buy the rumor of a substantial tax cut. However, once the cuts are announced, please book profits in the ensuing buying stampede.
On the other hand, if the tax cuts fail to materialize, keep the buy list ready to enter on any fall, which is closer to 8% to 10%.
Featured image courtesy of Shutterstock.
U.S. Nonfarm Payrolls Unexpectedly Decline in September
The U.S. job machine slowed significantly in September, as Hurricanes Harvey and Irma ripped through the southern states, disrupting local economies in their wake.
Overall nonfarm employment fell by 33,000 last month, following a revised gain of 169,000 in August, the Department of Labor reported from Washington. Analysts in a Bloomberg survey forecast an increase of 100,000.
The jobless rate declined to 4.2% even as workforce participation rose. That’s a level not seen since 2001.
Signs of wage inflation were present last month. Average hourly earnings rose at a faster 0.5% on month and 2.9% annually, official data showed.
Earlier this week, payrolls processor ADP Inc. said U.S. private sector employers added 135,000 positions last month. Economists had projected 98,000.
Hurricane Harvey made landfall in Texas at the end of August, triggering the biggest weekly spike in jobless claims since 2012. A total of 298,000 Americans filed for state unemployment benefits in the week ended Sept. 2, a gain of 62,000 from the week before.
September was the first negative reading on payrolls in seven years. Hiring is expected to rebound in the fall as the states of Texas and Florida resume cleanup efforts in the wake of hurricane season.
Solid employment growth has been one of the few mainstays of the U.S. economic recovery, prompting the Federal Reserve to gradually normalize monetary policy. The Fed is widely expected to raise interest rates again before year’s end. The Fed’s “great unwind” of its balance sheet will begin this month at a rate of $10 billion.
The report had no immediate impact on the currency markets, with the U.S. dollar index (DXY) rising gradually shortly after the data were announced.
«Featured image from Shutterstock.»
BOJ Rate Decision: Bank of Japan Keeps Policy on Hold After September Meeting
The Bank of Japan (BOJ) has voted to keep its trend-setting interest rate at record lows, as policymakers continue to rely on record stimulus to keep the economy humming.
BOJ Policy Decision
In an 8-1 vote, the BOJ kept its benchmark interest rate at -0.1%, where it has stood since January 2016. The decision was widely expected by economists, who say the BOJ is unlikely to budge on monetary policy anytime soon.
The BOJ also maintained its purchase of Japanese government bonds (JGBs) so that the 10-year JGB yield remains at zero percent. Meanwhile, annual bond purchases continue to be held at ¥80 trillion.
The BOJ shifted course on monetary policy last September when it made yield-curve targeting its central concern. Since then, it has been status quo.
Economic Picture Brightens
Central bankers have been largely hands-off to let monetary policy do its job. Recent data suggest ultra-loose policies are finally having their desired effect. Japan is currently in the midst of its longest period of uninterrupted growth in more than a decade. Quarterly gross domestic product (GDP) expanded 0.6% between March and June, the fastest in more than two years.
In annualized terms, the economy expanded 4% in the second quarter, official data showed. That was much bigger than the 2.5% annualized gain forecast by economists.
Japan has now been on the right side of growth for six consecutive quarters and nine of the past 11.
Strong domestic demand and a synchronized global recovery lifting Japanese exports have been the main factors behind the growth.
Despite solid growth, inflation continues to lag the central bank target of 2%. Core inflation rose in July for the seventh straight month, but came in at just 0.5%. National CPI also expanded 0.5% annually in July for its seventh straight gain.
Inflation has been so disappointing that the BOJ recently postponed its inflation deadline for the sixth straight time. The move highlights the growing frustration with low inflation under the Abe regime.
Yen Losing Ground
Japan’s currency declined again on Thursday to trade at fresh two-month lows. The dollar-yen (USD/JPY) exchange rate reached a session high of 112.65 before paring gains. At the time of writing, the pair is up 0.2% at 112.51.
The yen has been in free-fall for the past two weeks as risk sentiment returned to the financial markets. The yen is a highly liquid reserve currency that usually receives strong bids during periods of instability. With investors pouring money into stocks, the yen has fallen by the wayside in recent weeks.
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