Why the Budget Mess Won't Matter
We've learned not to expect answers from Congress and the president anyway. So the markets are betting that the world's central banks will keep things rolling along, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
The question from the audience during a Saturday afternoon panel at the MoneyShow in Orlando was direct: How did we think the coming mess in Washington—the battle in March, April, and May over the mandatory budget cuts called sequestration, a continuing resolution to fund the federal government, and another increase in the debt ceiling—would affect the financial markets?
The gasp of surprise was theatrically audible after my answer: I don't think it will have any effect.
My response wasn't for shock value. I really do think the markets are unlikely to move much in response to whatever Congress and the president do—or don't do—over the next few months. I don't think that's because the US deficit isn't important, or because the US budget isn't a mess, or because Washington can't tank the real US economy. I just don't think that the market is going to go down on bad news from Washington.
Whatever the fears of individual investors about our economic and financial future—and I think those fears are entirely justified—the big money that dominates the financial markets has decided to put its faith in the actions of the world's central banks.
Believing the Fed Can Fix Anything
If things go wrong in Washington—and I find it hard to imagine that they won't—central banks will ride to the rescue again, this belief goes.
Even though further expansion of the balance sheets at the Federal Reserve or the European Central Bank might seem like bad monetary policy, Wall Street is convinced that central banks don't have a choice.
Faced with declining asset prices because of stupidity in Washington, Fed Chairman Ben Bernanke and ECB President Mario Draghi will throw more money at the markets. This is a globalized version of the "Greenspan put," the determination of the former Fed chief to support the markets that encouraged the risky financial behavior that led to the global financial crisis of 2007.
This time we've got a global put. The markets are saying that it's safe to keep betting the market in global financial assets will go up, because central banks will bail out the markets if anything goes wrong.
On the surface of it, this belief by a majority of the world's money seems hard to understand. After all, we've already witnessed an almost unimaginable increase in the balance sheets of the Federal Reserve and the European Central Bank.
The Federal Reserve's balance sheet hit $2.92 trillion on January 10. That's roughly $2.5 trillion higher than the $488 billion of January 19, 2011. The European Central Bank's balance sheet hit a high of $4.15 trillion in June 2012. That was an increase from $2.98 trillion in January 2011.
Now, most discussions about the huge balance sheets at the Federal Reserve and the European Central Bank have focused on the distortions to the financial markets that these balances represent. The Fed is the Treasury market for many maturities of bonds, because it has been buying in such large amounts and for so long to push money into the economy.
The question of when these central banks will start reducing the size of their balance sheets has been asked. If they don't start taking some of the money they've poured into the markets, they risk another asset bubble or a jump in inflation when growth picks up in the United States or returns in Europe.
The most recent set of minutes from the Federal Reserve Open Market Committee indicates that the Fed leaders on that key committee have talked about ending the current program of buying $85 billion a month in Treasuries and mortgage-backed securities by the end of this year or even sooner. For its part, the European Central Bank has slightly reduced its balance sheet in the past six months.
In the long term, reducing the balance sheets of these two central banks is indeed imperative. And, in the long term, the appropriate worries are whether the banks will be able to sell the assets they've bought in the financial markets back to the financial markets without either depressing prices of those assets or sending interest rates climbing to levels that hurt the real economies in their respective jurisdictions.
But in the short term, the financial markets have a point. The two central banks have flooded the markets with cash by buying assets for their balance sheets in order to prop up the value of financial assets—home prices in the United States, government debt prices in Europe—because that looked like the best way to counter the lingering effects of the global financial crisis and to get economies in the United States and Europe growing again.
With the recovery in the United States proving remarkably tepid—in the fourth quarter, the US economy actually contracted by 0.1% due to a decline in government spending—and with much of Europe in recession or near recession, it's hard to imagine that the Fed or the ECB will simply walk away from the trillions they've put into this strategy and say, "Sunk cost—no use throwing more money into those strategies."
So Congress and Obama Don't Matter
From this perspective, the inability of governments—in Washington, along with Athens, Rome, Lisbon, London, Madrid, etc.—to come up with plans to stimulate their economies is not only an abdication of responsibility for putting in place fiscal policies that would address current economic woes, but also a guarantee that central bank balance sheets will continue to expand.
If the one thing that the financial markets fear is the end of central bank stimulus, the political dysfunction in Washington makes that end less likely. If Washington is gridlocked and can't even agree on a budget for the federal government, that just pushes more responsibility for the economy onto the Fed.
I doubt that financial markets will rally on the prospect of a shutdown of the federal government because Congress can't pass either a budget or another continuing resolution. But I think the financial markets are perfectly capable of holding their ground during a spring spending-cuts/budget/debt-ceiling mess, because the mess guarantees that the Federal Reserve will keep pumping money into the financial markets.
The odds that the financial markets will sail through the spring money mess also get a boost from the recently completed fiscal cliff episode. That example of Keystone Kops government didn't tank the financial markets, despite all the worry and warnings.
You can argue that the relatively happy ending—from a market perspective—doesn't mean the next crisis will have similarly little impact. But at least part of Wall Street's current lack of worry about a spring debacle in Washington is a result of the sky not falling in December.
And finally, I think the odds that a spring debacle in Washington won't matter much to the financial markets get a boost from the extremely low approval ratings scored by Congress. Congress averaged an approval rating of 15% in 2012, according to Gallup polls. (Surveys by Public Policy Polling show Congress trailing cockroaches in the approval ratings.)
With that kind of ranking, nobody expects Congress to do anything but the stupid thing. I think that contempt for government also blends into a belief that whatever government may or may not do isn't important. And that works to lessen worries over the spring spending-cut/budget/debt-ceiling mess.
The market's faith in central banks is touching, but it leaves me uncomfortable. In the past decade, central banks have certainly demonstrated that they aren't infallible and that their policies aren't all-powerful. Betting that the world's central banks will always bail out the market seems relatively risky, given recent history.
And I'm made even more uncomfortable by the realization that a continuation of this rally in the face of the coming deadlines in Washington depends on sentiment. It's not that the financial markets know that the Federal Reserve and the European Central Bank will support asset prices at current levels or better. The rally depends on a belief by traders and investors that central bank policies mitigate—or even eliminate—downside risk in the March-April time frame.
Once again, I'm looking at a market that could (and I believe will) go up on sentiment—if I'm reading sentiment correctly, and as long as current sentiment doesn't shift. But sentiment is clearly the basis of this stage in the rally.
I'd sure like to have a more solid foundation than that for betting that this rally will continue. I just don't think that I'm going to get that foundation in the near term.
Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.