DOES WASHINGTON REALLY MATTER ? / BARRON'S MAGAZINE

Wall Street's Best Minds

 | FRIDAY, OCTOBER 18, 2013

Does Washington Really Matter?

By REBECCA PATTERSON  

Investor behavior suggests that government dysfunction is a sideshow to other variables, writes Bessemer Trust's chief investment officer.

The 16-day government shutdown and threat of U.S. default cost the U.S. economy billions of dollars, sharply depressed business and consumer confidence, and dented America's political and financial credibility with the world.

Yet cyclical assets are stronger – it appears investors are saying with their capital that the government dysfunction, while notable and depressing, is a sideshow to other variables.

While we agree with the market assessment near-term, one of the keys to good risk management is weighing when a sideshow might turn into a main event – in the case of U.S. politics, we believe risks are relatively low into the 2014 mid-term elections.

For the average investor, does Washington matter or not?

On one hand, the 16-day government shutdown took a heavy toll on the United States. According to Standard and Poor's, the shutdown took $24 billion out of the economy and reduced at least 0.6% off annualized, fourth-quarter GDP growth.

Even with the government offices reopened, it may take some time for business and consumer confidence to bounce back – especially knowing another policy debate could erupt within months. A Gallup Poll released Oct. 15 showed consumer confidence in the economy plunging 17 points in two weeks – similarly sharp declines have not been seen since the summer 2011 debt-ceiling debacle and the September 2008 Lehman bankruptcy.

Less immediate but perhaps even more important, the U.S.' credibility overseas has been wounded. Monday, China's state-run news agency Xinhua published a commentary pushing for a "de-Americanized world." China and Japan together own about $2.4 trillion in U.S. Treasuries. Without an equally liquid, "deep" bond market outside the U.S., it is unlikely either country could quickly or significantly reduce U.S. bond holdings. That said, their trading activity in U.S. markets could easily create unwelcome bouts of volatility.

The hit to growth and confidence, as well as global credibility, together with potential for more political dysfunction (the next shutdown could come as soon as mid-January), would seem serious enough to weigh on investor sentiment, and in turn, financial markets. But that has not been the case – there is a big disconnect between Washington and Wall Street. Indeed, during the 16 days of the shutdown, the S&P 500 rose about 2.4%.

What gives? We would point to three main factors to help understand the D.C.-NYC disconnect. First, many investors (ourselves included) counted on a repeat of other recent episodes where Washington took Wall Street to the edge of the cliff, but didn't jump. It's interesting that during the previous 17 shutdowns (going back to the 1970s), U.S. equities also rose, probably at least partly on the same notion that policymakers prefer not to risk their seats with such action. Second, there is a reasonable assumption that the economic consequences of the shutdown will result in a Federal Reserve even more reluctant to change its uber-easy monetary policy anytime soon – we will hear more on this front at the next FOMC meeting on October 30. (The U.S. 10-year Treasury yield started falling Wednesday on hopes for a deal - from around 2.76% to levels now around 2.63%.) Lower borrowing costs and ample liquidity, all else equal, are supportive for cyclical assets.

Third, despite Washington, the broader global economic trend is improving, albeit gradually and in fits and starts. Even with a small step back in September, business confidence in recent months is suggesting third-quarter global growth at its strongest level in almost one and a half years. For investors, even U.S. focused ones, this global trend is good news, since what happens globally is increasingly as important as what happens at home. It's worth remembering that nearly half of S&P 500 sales today come from overseas. That global influence is partly responsible for a U.S. earnings season getting off to a decent start: through Wednesday, of the 44 U.S. companies that had reported, 70% beat earnings expectations and 52% beat sales expectations.

We have added incrementally to our equity overweight this year, including in mid-September. We see supports from continued easy developed-market central bank policy (the scale of Japan's asset purchases make the Fed look downright demure), relatively improving global growth, and valuations. On this last point, we would highlight that forward-looking price-earnings ratios suggest stocks that are fairly priced but not yet rich. Additionally, in the case of the U.S. equities, we see support as well from continued, aggressive share buybacks.

Good risk management means that we cannot count on history repeating again - we still need to worry about the possibility that the Washington-Wall Street disconnect disappears; that policy dysfunction becomes a more significant market driver. A diversified portfolio approach helps protect us against that risk. So, too, does frequent "what if" stress tests of a portfolio, to plan what asset-allocation changes may be required under different macro- or policy scenarios.

For now, our disconnect is mainly towards Washington. That is, we are depressed and hopeful at the same time. We are depressed that things have gotten so bad in terms of Capitol Hill compromise. But we are hopeful that opinion polls showing evaporating approval ratings both of Congress and the White House, coupled with aspirations for 2014 mid-term elections, might change dynamics going forward. Talk about upside market risk – no investor today (sadly, us included) is discounting the possibility that Washington actually agrees on a longer-term fiscal plan that would be good for the U.S. economy and its standing with the rest of the world.

Rebecca Patterson is chief investment officer at Bessemer Trust.