The impasses in Washington over spending and the debt ceiling were resolved this week, as we predicted in the last (October 15) edition of Market Notes. The last-minute agreement essentially kicked the can down the road. The government is funded until January 15. The U.S. Treasury may continue borrowing until February 7, and "extraordinary measures" will allow bills to be paid for some time thereafter. In the trading that followed the agreement, the stock market reached new highs and the yield of the 10-year U.S. Treasury note fell, pushing its price higher.
Another downgrade of U.S. Treasuries would not be shocking
The agreement and subsequent market gains belie ongoing concerns. On October 15, Fitch Ratings placed its AAA rating on long-term U.S. Treasury securities on "negative credit watch." In announcing its decision, the firm said, ". . . the outcome of a subsequent review of the [nation's long- and short-term] ratings would take into account the manner and duration of the agreement and the perceived risk of a similar episode occurring in the future."1
On October 16, The Washington Post observed:
"For the next few months, as the government approaches another debt limit and Fitch evaluates how the political system responds, the threat of a downgrade remains—and with it the risk of a broad rise in borrowing costs, not just for the federal government but also for countless state, city and local agencies whose credit ratings could be at risk as well."
Reuters has reported that the safe-haven reputation of U.S. Treasury bills took a beating during the latest debt ceiling fight, and that it may not be regained soon. The continuing instability in Washington has an immeasurable, negative effect on the confidence of businesses, investors, and consumers.
We expect the next round of negotiations to be less painful, but not pain-free, because so little was gained at a high cost economically and politically. By some estimates, the partial shutdown created a drag in the neighborhood of 0.5% on fourth-quarter U.S. economic growth.
Corporate profits likely to take center stage
With the crisis in Washington averted for now, attention turns to corporate earnings reports for the third quarter and beyond. According to FactSet Research Systems, of the 97 companies in the S&P 500 Index that have reported third-quarter results, 69% have topped the average profit estimate of analysts and 53% have outpaced the sales estimates. The percentage of profit "beats" is below the four-year average. The earnings growth rate for the quarter is 1.3%. Fourteen companies have issued negative guidance for earnings, while four have issued positive guidance. In addition to concerns about the government shutdown, companies are commenting on the negative impact of exchange rates as the dollar has appreciated, making U.S.-produced goods less attractive than they were before the strengthening of the U.S. dollar.
Our outlook and asset allocation preferences have not changed
The partial shutdown will create noise in economic data for some time, and this may contribute to market volatility. Nonetheless, we expect the slow economic recovery to continue. We continue to prefer stocks over bonds, cash, and inflation hedges.
New investment communications coming soon
This is the final edition of Market Notes. My colleagues and I have been writing them, more or less biweekly, since the beginning of 2009. Also departing is our weekly Investment Dashboard. We hope you've found them informative and interesting, but we decided that the time has come to refresh our highest-frequency investment publications. We hope you will find our forthcoming, weekly Market Briefs to be easier to read and mobile-friendly. Each edition of Market Briefs will be accompanied by an Economic Dashboard, a Financial Markets Dashboard, and an Investment Policy Dashboard, allowing you to focus more easily on the subjects that interest you. Finally, a new Market Insights commentary will share the thinking of our Investment Strategy Team and the rationale for any changes in the structure of our model asset allocation strategies. You can expect to receive Insights on at least a monthly basis, and your feedback on all our publications is welcomed.
1 Standard & Poor's lowered its rating on long-term U.S. Treasuries from AAA (outstanding) to AA+ (excellent) in August 2011. Fitch Ratings uses a similar ratings progression, AAA through C.
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