Forward Guidance and a troubled Tea Party

By Emma Black (Portfolio Manager at Tier One Capital) 4 October 2013

Global markets are enduring further volatility following a plethora of political and economic events that have unfolded over the last few days. Let us first go to North America, where the US government is under partial shutdown for the first time in 17 years, after Congress failed to agree terms for a new budget after Republicans in the House of Representatives called for a delay to President Obama’s healthcare reform – termed Obamacare – as condition for passing the bill.

Obamacare, or more formally the Patient Protection and Affordable Care Act of 2010, is the largest restructuring of the US healthcare system for decades. President Obama has been clear in its objective of extending health insurance to the 15% of the US population that was estimated to be ineligible under prior legislation, amongst a number of other changes such as forbidding insurance companies from restricting coverage to those with prior conditions. All sounds good from a socially responsible perspective, but Republicans claim that the change had imposed heightened costs for businesses, while the BBC also indicates that the Republican Party largely feel that it represents an “unwarranted intrusion into the affairs of private businesses and individuals”. This ongoing debate between the Democratic and Republican parties reached a head when the Republican-led House of Representatives pressed for a delay to the enactment of Obamacare as a condition for passing the budget bill.

As a result of this standoff, the US government has been rendered into partial shutdown, with more than 700,000 federal employees now subject to unpaid leave with uncertainty over whether or not this will lead to any payback once the shutdown ends. The effects for markets have been debated, with Goldman Sachs estimating that a three-week shutdown could lead to a fall of up to 0.90% from Q4 US GDP data. Société Generale have indicated that this would likely be recovered in Q1 of 2014 but the wider effects could be more pronounced if personal consumption data is hit as government workers continue to be subject to unpaid leave. Moreover, the Baker-Bloom-Davis Economic Policy Uncertainty Index has shown a spike following the shutdown, reigniting concerns moving forward.

The larger issue at hand however lies in the upcoming deadline for raising the US debt ceiling on October 17th. If this does not happen, then the US will default as it runs out of money leading Christine Largarde (IMF) and the US Treasury to warn that this could evoke a financial crisis as damaging as in 2008 or worse. President Obama supported her concerns indicating that an economic shutdown following a US federal default would kill the continued improvement that we have seen in US markets. The US Treasury, addressing the impending debt ceiling negotiations, indicated that default would lead the dollar to fall, US interest rates to “skyrocket” and would cause a freeze in credit markets. Already uncertainty is leading short-term interest rates to rise relative to longer-term rates, reflective of expectations of the October 17th deadline.

Here in Europe, we have also seen announcements from the European Central Bank filtering into markets. Indeed we are now witness to Central Banks walking a fine line between forward guidance policy on interests and forward guidance on stock prices, particularly after vice-president Vítor Constâncio announced his view that European banks are undervalued relative to their US counterparts. Constâncio stated that European banks have slightly higher median common equity tier one capital than those in the US, directly implying an undervaluation of stock prices on the part of the European Central Bank.

We have entered a phase of markets whereby Central Banks and Governments do not actually have to take action for markets to react. Through communication alone, markets are moving under the puppet-hands of policymakers. For example, markets have continued to bounce around at each announcement of an expectation that tapering will begin – even though no action has been taken, and the expectation of tapering starting at some point already being a given!

What has been relatedly interesting given this has been the lack of a stock market reaction to the partial shutdown in the US. The S&P 500 yesterday (October 1st) closed +0.80% up, falling only -0.07% today (October 2nd), while Gold rose +2.48% today (October 2nd). The unpredictability of markets continues to be shown in this regard. What is warned though, is that this only persists over the short-term. As October 17th looms, and day after day the US government remains in partial shutdown, this uncertainty will most surely begin to filter into market behaviour.