The markets are complacent and are ascribing a near-zero possibility of a technical default -- that is, missing part or all of the mandatory spending (Medicare, Social Security, etc.) but paying interest on the government's debt while maturing debt is rolled over. By contrast, I don't see the possibility of an adverse outcome as trivial. On Sunday, Boehner reported that the House will not pass a clean debt-ceiling bill. At the same time, Obama has stated he will only sign a clean bill. That is what we call a standoff. While I continue to view the baseline case as an Oct.16-Oct. 17 compromise, the odds of a technical default are at least one in three. (Note: It is increasingly clear that prioritizing payments is difficult after the Oct. 17 deadline, as Treasury payments are programmed day by day and not by recipient.) This is an uncomfortably high possibility relative to what the markets appear to be pricing in. Here are my four basic concerns: 1. The Republican Party remains polarized and dysfunctional. 2. The Democratic Party remains uncompromising of view. 3. My contacts in Washington, D.C., continually tell me that there are little signs of movement (even under the surface) in dealing with the shutdown and debt-ceiling issue. (As I wrote, the two issues have merged as one.) In canvassing some of these contacts over the weekend, they used words like "immovable," "chaotic," "challenging" and "hostile." If you talk to the participants in the process, as opposed to the bookies betting on them in the marketplace, they are surprised that the capital markets have been as calm as they have. The dynamics of a compromise remain complex, and the pathway to that compromise, according to the central players (who understand the forces at work), is still not clear or under control. 4. Both the Democrats and Republicans appear incapable of dealing with each other. If anything, their hostility is growing stronger. As I have continually opined, now is not the time to be over one's skis, either long or short. It is a period to have above-average cash reserves, and it is an excellent time to watch how things sort themselves out, particularly considering how far the market has advanced.
"We are not going to pass a clean debt limit.... The votes are not in the House to pass a clean debt limit."
-- Speaker John Boehner, ABC's "This Week With George Stephanopoulos"
"The U.S. is on the verge of going somewhere we've never been if Congress fails to raise debt ceiling."
-- Treasury Secretary Jack Lew, NBC's "Meet the Press"
Our Economy Is Vulnerable to Political DysfunctionGiven that the U.S. recovery is barely at escape velocity and that it can be argued that the weak trajectory of growth is still not self-sustaining, it remains uncertain how vulnerable the domestic economy is to the high drama in Washington. In all likelihood, the longer the stalemate continues the more significant the dent to business and consumer confidence. The two previous budget impasses had a more adverse impact on the U.S. stock market and on economic growth than what we have seen this time (further confirming my view about the current level of complacency). The bottom line is that we must question whether the risk is that three strikes of budget impasses (over the past several years) and the (fragile) economy is out. Ten days from now, in all likelihood, there will be a resolution in Washington. And, at that time, we can again refocus on the challenges to sales and corporate profits in the upcoming quarters, which could pose an even larger threat than the debates on budget and debt-ceiling issues.
No Taper Until March 2014Meanwhile, it is important to recognize that the current shutdown will bring a continued halt to the release of government economic data. If I am correct that the decision comes close to Oct. 17, the economic data vacuum will make it difficult for the Fed to properly assess the economic condition on a timely basis. But even after a possible budget resolution (after Oct. 17) the economic data will grow more ambiguous, further complicating its interpretation by the Fed. This probably means that a tapering is unquestionably off the table this month and, in all likelihood, off the table in December. The first opportunity after December is January 2014, but I wouldn't rule out March 2014 as the month that a tapering is finally initiated.
What to Do?With the market likely influenced heavily by the machinations in Washington (and neither fundamentals nor technicals holding the key to investment success), I remain an opportunistic trader, not a member of the buy-and-hold crowd. Looking beyond the current impasse, our trading and investment focus will soon be back on a lackluster top-/bottom-line and profit margin (70% above five-decade averages) outlook for large U.S. corporations (which has likely deteriorated as a result of the Washington follies), an already-seen 2013 expansion in P/E multiples (from less than 14x to more than 16x) and a still-scary and unresolved global geopolitical backdrop. Frankly, I have too much respect for money to be deeply committed or to fake and pretend conviction (as I see many bulls and bears do) at today's market levels, given the overall uncertainties expressed in this morning's missive. Reward (upside) is simply not particularly attractive relative to the risks (downside).
This column originally appeared on Real Money Pro at 7:54 a.m. EDT on Oct. 7.