If only this clever marketing slogan for Las Vegas held true for our nation’s capital! The recent dithering activities of our politicians in the “Sin City” along the Potomac has created significant distaste across the world and cast a shadow over financial markets. Entrenched positions on both sides of the aisle have led to the government shutdown and the very real risk of our government running out of money without an increase in the borrowing debt ceiling. Clearly, decisions made by our elected officials over the next few days and weeks will have important ramifications for all of us and carry risks and opportunities to our financial wellbeing.
Thus far the stock market has taken the political dysfunction in stride while remaining sensitive to headlines in Washington, falling on signs of gridlock and rallying, sometimes quite strongly, on hints of an imminent deal.
On the surface, the bond market has also shrugged off the government closing and debt ceiling discussions with longer term interest rates largely unchanged. However, as the rhetoric has gotten louder over the past week, investors have sold billions of dollars in short-term government debt amid concerns that a U.S. “default” would delay payments of interest and principal. This selling led to a spike higher in short-term interest rates and created the unusual inversion where yields on treasuries maturing in one month are 2x-3x higher than those maturing in three to twelve months.
Even foreign governments are openly displaying their distaste for the political drama in Washington. The still-slim risk of even a “technical” default has heightened worries over the stability of money market funds and the use of treasuries as borrowing collateral. While the risks of any form of default are not insignificant, we believe Washington has heard the screams and are close to a deal to take the near-term risk of default off the table.
We see much of this discussion as noise and anticipate the future direction of interest rates will ultimately be driven more by the Federal Reserve’s monetary policy going forward. While the Fed’s quantitative easing efforts cannot go on forever, the nomination of Janet Yellen, who is expected to continue the accommodative monetary policies of Ben Bernanke, has lessened any near-term concerns about higher short-term rates or a tighter monetary environment.
What are we doing?
Our strategies have not changed dramatically amidst the theater in Washington. While fiscal concerns over the U.S. budget and spending will continue to dominate the headlines in the coming days and weeks, longer-term, improving economic fundamentals driven by what remains a still-sputtering recovery will again be important.
In the U.S., real estate and housing remain bright spots. Improving credit quality has driven the rebound in commercial lending and low mortgage rates continue to fuel both new housing demand and refinancing activity. Yet the sharp decline in mortgage applications in September on the heels of the over 100 basis point spike in mortgage rates in late summer highlights how fragile the recovery remains and how dependent it is on easy access to cheap money.
In recent quarters, corporate revenue and earnings growth has underwhelmed and analysts continue to reduce future earnings estimates. Valuations of U.S. stocks remain full by most measures; however, at least over the near-term, the accommodative monetary policy is supportive for stock prices, especially in what remains a challenging environment for earnings growth.
With this backdrop, we continue to seek out individual opportunities in U.S. equities where we believe the risk/reward is most favorable while remaining alert to opportunities to trim positions that have grown beyond our targeted position size or where valuation is stretched beyond comfort.
Overseas, we see prospects for a gradual, yet uneven, recovery in parts of Europe along with an accommodative European Union (EU) monetary policy offering a constructive back drop for stocks. While southern Europe remains mired in fiscal issues and political distractions, the UK and Germany are leading with stronger labor markets, a recovering housing sector and growing consumer spending and manufacturing activity. Though the monetary circumstances of the EU cause the region to be somewhat tied together, we believe the relative underperformance of EU stock markets has created pockets of opportunity for investors.
Although we expect additional volatility both up and down for emerging market (EM) stocks, we believe these markets still present opportunity for long-term investors. Though EM stocks have rallied strongly since their summer trough, valuations remain attractive in what is still a secular growth environment for infrastructure development, rising incomes and consumer spending.
While disappointed and at times disgusted with the political drama in Washington, we are working hard to not let it dominate our thinking or cloud our perception of longer-term risks and opportunities. The future is always uncertain and no one knows exactly what compromises and surprises lay ahead. We are optimistic a deal will be struck to avert the worst case scenarios and that investors can again shift their attention to what remains a slowly improving economic environment. Hopefully, the politicians who are eager to dig in and “gamble” with our future will take advantage of the cheap flights to Vegas where they can take odds on their own financial wellbeing, not ours.
As always, please feel free to contact us with any questions or comments.