Stop us if you’ve heard this one before. With a deadline fast approaching, congressional Democrats and Republicans are still bogged down in critical budget negotiations, with each side wary of ceding too much ground on specific deficit-reduction measures – whether tax increases, entitlement cuts or other spending decreases – for fear of alienating key constituencies in the coming election year. All the while, investors are growing increasingly anxious about the outcome, and the potential consequences of any Washington action or inaction.
Sadly, it’s no joke. As the 12-member Super Committee tasked with finding $1.2 trillion in deficit-reduction measures continues to work toward its November 23 deadline, it’s impossible not to think back at least briefly to the painful debt-ceiling negotiations of this summer. The debt-ceiling deal reached just before the August 2 deadline was quickly followed by Standard & Poor’s downgrade of the U.S. credit rating. The stock market, which had already been spiraling lower as the negotiations dragged on, responded to the S&P move with its worst day since the financial crisis of 2008, with all the major indexes losing 5.6 percent or more. After two more months of volatile trading that saw stocks reach their low for the year on October 3, the market has rallied back strongly, with the Dow Jones industrial average gaining 13.5 percent since then.
Now, even as investors continue to buy, and continue to focus on the debt crisis in Europe, some are once again starting to fret about the domestic political risks that could derail the rally. “Many investors are shifting their attention from Athens and Cannes to Washington given the looming November 23 deadline,” Citigroup’s Chief U.S. Equity Strategist Tobias Levkovich wrote in a report earlier this month.
But if the interest from investors has increased as the hours to the deadline tick away, the optimism about a deal has not, given Congress’ recent track record and the political pressures that come with the run-up to an election. “There’s a large segment of the market here that thinks that there will be no agreement at all from the debt commission or that the recommendations are going to be pretty meager,” says portfolio manager Erik Weisman of MFS Investment Management. A Citigroup survey of institutional investors conducted in mid-October found that more than 60 percent of respondents felt the Super Committee would fail to come up with the mandated $1.2 trillion in combined spending cuts and tax increases.
Those low expectations suggest less market downside in the event of a Super Committee deadlock, but the days ahead could still be bumpy, a number of market strategists say. Fred Dickson, chief investment strategist at D.A. Davidson & Co. in Lake Oswego, Ore., warns that the week leading up to the deadline in particular could be rocky as media attention turns to the proceedings in the Capitol.
But Dickson and other veteran investors expect the market turmoil to be relatively muted, even if the Super Committee fails to agree on a package. “While we suspect that some volatility around headlines can be expected in the latter part of November,” Levkovich noted in his November 4 report, “we do not see it as crushing the recent rally.” Stock market valuation levels, at a relatively low 12 times estimated 2012 earnings, could provide a cushion against any slide, Dickson says, adding that the market could drop 2 or 3 percent “for a week or so,” but if the headlines out of Europe haven’t scared investors off, bad news from the Super Committee won’t either. “The market is up over the last six weeks as Greece and Italy have spun a much more complicated economic picture than what Congress would be delivering,” he says.
The fallout from a Super Committee failure could include another cut to the U.S. credit rating, but even that scenario isn’t being viewed with the kind of uncertainty and trepidation that preceded S&P’s August move. “It would be more of a media headline than a market event,” Dickson says. Similarly, in a late October note to clients predicting “at least one credit downgrade in late November or early December when the super committee crashes," Bank of America Merrill Lynch economist Ethan Harris wrote: “We expect a smaller hit to the markets and confidence with the next downgrade.”
Ultimately, for Wall Street at least, the stakes in this round of deficit talks simply aren’t as high as they were over the summer, given that the debt-ceiling has been raised, eliminating fears of a potential default by the federal government. On top of that, any tax increases or spending cuts that get implemented wouldn’t take effect until fiscal 2013, eons away for Wall Street investors who are more likely to focus on policy decisions likely to have a greater impact on the economic forecast fr 2012 – specifically, whether Congress renews the unemployment benefits insurance extension and payroll tax cut due to expire at the end of the year.
Some analysts have estimated that not extending those two programs could cut a full percentage point off next year’s GDP. “If neither of those benefits are extended,” says Weisman of MFS, “then 2012 is going to be a very dicey year, and you’ll have a pretty significant fiscal cliff that you could fall off of, which would be made all the worse if the situation in Europe deteriorates. If on the other hand, both of those benefits can be extended into 2012 then the outlook would be significantly improved.”
A Super Committee failure could even turn out to be a positive development for investors, if it ramps up pressure on Republicans and the Obama administration to find common ground on those other looming issues. “If no agreement is reached in late November,” Levkovich noted, “it seems highly likely that the White House and Congress will have to find some grounds for compromise since both probably do not want to go into an election cycle with essentially perceived new tax hikes and spending reductions.”