As Americans head into their Thanksgiving long weekend, they will have plenty of things to be thankful for. Unfortunately, an effective government will not be one of them.
While we have not been startled by the lack of political leadership in Europe in dealing with the region's debt crisis (to date, the EU had still not ratified the most recent rescue and stability program), there was a feeling that members of Congress would get their respective acts together and put to rest any doubts over fiscal repair in the U.S.
The so-called 'super committee,' established back in August after the rating downgrade, was given one task and that was to come up with a proposal to cut a further $1.2 trillion from the federal deficit over 10 years. A large number, yes, but considering this is only 10 per cent of the current annual shortfall, the task wasn't insurmountable. Some tax tweaks here and there, and a thorough cupboard cleaning of inefficient federal agencies would have achieved the desired objective and brought some peace to equity markets and cool down rating agency tempers. Alas, with only a few days before the Nov. 23 deadline for a proposal, members of the committee pre-announced that there would be no agreement. Markets recoiled and hopes of a late-year recovery in stocks has faded, as this was one of the few silver linings left in an otherwise dark cloud hanging over Europe and the global economy.
All is not lost, however, since failure to produce an agreed upon proposal simply takes the beltway to plan B -- an automatic series of spending cuts in 2013 geared towards the $1.2 trillion deficit haircut. If it were not for this contingency, the rating agencies would have been scrambling this week to either cut the U.S. rating a first time (for the two majors that didn't already knock the triple-A off the shelf) or guidance for additional downgrades by Standard & Poor's. At the time of writing, all but Fitch had indicated that they were leaving their respective ratings in place, but this could all change come 2012. The reason is that the automatic cuts slated for 2013 could become un-automatic as the election race heats up. If, for whatever reason, those cuts get kicked down the road, I believe the agencies will waste no time in slicing into the U.S. debt rating. If you thought the shake-out in equities back in August was disturbing, such a scenario would be worse.
Moreover, there is less scope for U.S. bonds to avoid being hit as well in that situation given that bond yields are significantly lower today than they were back before the summer fiasco. For example, the 10-year U.S. Treasury was still up near three per cent going into the debt ceiling debate and subsequent downgrade, compared to levels below two per cent this week. Conversely, the value of the U.S. dollar is higher today than it was before August, with the DXY index trading up near 80 -- roughly a seven per cent gain. Any flight to safety considerations by investors in the face of a U.S.-led panic in stocks would have to be measured against both the risk of a correction in the dollar, without much compensation in terms of actual yield on bonds.
Some view these developments in a light similar to the MAD (mutual assured destruction) equilibrium that existed between the U.S. and Soviet Union back during the Cold War. Given that continued political ineptitude will lead to a worst case scenario with respect to U.S. capital markets, and hence individual American household portfolios, the endgame result should be that Republicans and Democrats get together to either push forward sustainable deficit reduction proposals or allow the automatic 2013 cuts go through. The problem for the equity market is that participants feel that politicians won't adhere to MAD and that this uncertainty prevents a clear vision towards the medium-term outlook for the economy. In other words, there are now very real second-order effects from continued political inaction that puts the outlook in flux. That means two things. First, the odds of a Santa Claus rally are now lower. Second, volatility into 2012 will remain elevated. If this scenario unfolds, then politicians will learn at the polls just how much of a wasted opportunity this was.