The Envestnet Edge, October 2015

Politics and the markets: déjà vu all over again?

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So here we are again: in the silly season of an election year that has become a recipe for extreme rhetoric often incompatible with sober governance. The crisis du jour is yet another dance on the precipice of a U.S. debt default triggered by the looming deadline to raise the debt ceiling. Although it may be resolved by the time you are reading this, you can rest assured that, alas, this crisis is unlikely to be the last.

The short answer about what to do when cascading issues in Washington politics arise is to ignore them. Seriously. Most of these politically induced financial panics and crises get resolved before the worst comes to pass. Of course, it is always possible that this time (whichever time it is) will be the one when the game of chicken that the political class plays with the financial system goes terribly awry. Although possible, that worst-case scenario is relatively unlikely, at least judging by the past and probability. It is a risk worth monitoring, but not one that should shape fundamental market and investing decisions.

The debt ceiling—a historical perspective

Washington’s debt ceiling crisis has been part of an ongoing battle within the Republican Party, and is one reason behind House Speaker John Boehner’s sudden resignation. Although this particular episode is likely to be resolved, it is sadly indicative of what we reasonably can expect over the next year or more.

Once upon a time, raising the debt ceiling was purely a procedural process. The origins of the debt ceiling are fairly benign, and like many initial ideas, born of need. Starting in 1917, Congress changed the way the nation borrowed to allow a more efficient means to raise debt to fund the military build-up triggered by World War I. Since then, raising the debt ceiling has been authorized more than 90 times, the majority of which occurred after 1962.

Because an increase in the debt ceiling simply permits the U.S. Treasury to borrow commensurate with the spending that Congress has already authorized, it didn’t really occasion spending fights until the 1990s. Yes, debt ceiling increases in the 1950s and 1960s did provide Congress with an opportunity to deliberate over spending, but until the government shutdown in November 1995, no one had thought to use the authorization as a secondary tool to force budget cuts. Although the political ramifications were significant, and may have undermined the electoral chances of Republican candidate Bob Dole in 1996, the market reaction at the time was muted, as debt reduction was already well underway, and a default on payments was not in the cards.

That episode was repeated in 2011, and this time, it was touch-and-go whether Congress would allow a default on U.S. debt payments rather than authorize a debt ceiling increase. A breakdown in budget talks between Congressional Republicans and a Democratic White House ensued, which, in turn, led Standard & Poor’s to downgrade U.S. debt. The downgrade had almost no discernible effect on the U.S.’s ability to borrow, but the entire period was highly destabilizing for financial markets already on edge from the intensifying crisis in the European Union over Greek debt and its potential contagion to Italy and Spain. The result was a few months of intense and alarming decline in stocks and overall rate and market volatility.

We saw a smaller version of that repeated in October 2013, barely two years ago. The government again shut down over an impasse on budget and spending that shook financial markets, although less so than in 2011. The assumption then was that at some point the grown-ups in the room would find a way to avoid the worst effects of the logjam, and at least agree on a continuing resolution to fund the government, including interest payments on its debt. And indeed, that is what happened.

History may not repeat—but it frequently rhymes

Today, there is a similar assumption, which likely will be correct. At the same time, it also is likely that Washington, the budget, and all the assorted uncertainty about spending, debt payments, taxes, and future allocations not only will continue but also intensify.

Past market activity during these periods of politically induced economic flux suggests that volatility rises along with the noise of media and politics. Market direction also becomes harder to gauge, and decidedly tilts to the downside. But once the particular issue is resolved, however ineptly or imperfectly, markets go along their merry way, and investors tend to revert to the fundamentals.

A very short election year primer

The lesson here is not complicated, but it is important: As much as possible, filter out the political noise. For the vast bulk of investing decisions, it is a negative distraction.

Yes, government matters. Yes, what the federal government spends or does not, how it taxes or does not, and what regulations it passes shape the business and investing climate. But those are just one set of inputs.  Other inputs include the Chinese government, the European Central Bank, the statehouses of 50 states, the capital spending and hiring decisions of multinationals, the global cost of capital and goods, trade deals, political upheavals in various regions, and a very long list of other factors. And yes, the U.S. government accounts for nearly $4 trillion of spending each year, which is over one fifth of U.S. Gross Domestic Product, and larger than the GDP of most countries in the world. So it matters, just not to the degree that our focus on it suggests.

In addition, much of that $4 trillion is set, comprising Social Security payments and Medicare and Medicaid. The current spending debates are most acute over some of the least important aspects, financially speaking, of our budget, such as Planned Parenthood, accounting for about $500 million. As heated as those issues may be, they have no meaningful effect on our economic and investing landscape.

Over the next year, therefore, the wise course is to separate the politics of markets and the economy from their fundamentals. The two overlap, but they are distinct. That is easy to forget in the fray of an election, but vital to remember.

Advisor Takeaway
Budget debates and threats of government shutdowns are part of the political landscape.  They are real, but they should not dictate investment decisions.  History shows us that these issues ultimately get resolved (although not always perfectly), and can be accompanied by short-term stock price declines and rate and market volatility. The nearly $4 trillion U.S. budget is only one-fifth of our Gross Domestic Product, and most of it is accounted for in Social Security, Medicare, and Medicaid payments. It matters, but not to the degree our focus on it suggests:  other domestic and global inputs impact markets. As we enter an election year, investors would do well to separate politics from the fundamentals of the economy, and ignore the short-term noise.