Budget, debt ceiling gridlock not worrying investors ... yet

093013 marron
Donald Marron says lawmakers know they need to raise the debt ceiling, so they ‘should avoid self-inflicted shocks’ of waiting until the last minute.

As Washington policymakers deal with the deadline dramas of an expiring budget resolution and the federal debt ceiling, money managers and their institutional clients are taking it all in stride.

“You always have to worry about politicians doing what they do, but by and large I think the outlook remains fairly sanguine,” said Karim Basta, director of economic research for III Associates, a $2 billion hedge fund based in Boca Raton, Fla. Compared to similar debt ceiling and budget crises in 2011, “this year passed without any real drama,” Mr. Basta said. “We've seen the script before.”

The first deadline comes Sept. 30, when the current government spending resolution expires. Without another resolution or an extension of the existing one, the government will shut down, except for interest payments on Treasury securities and mandatory entitlement programs like Social Security.

The second deadline is tied to the federal government's statutory debt limit. All spending could screech to a halt sometime in mid-October, when the U.S. is projected to hit the debt limit of $16.7 trillion, unless Congress increases the limit.

Since both of these crises have been seen before, most observers expect an eleventh-hour compromise from Capitol Hill and the White House that will create new deadlines, if not solutions.

“In many ways, institutional investors are numb to this, but there is always a risk of something going awry, so don't ignore the debates,” said Karthik Ramanathan, senior vice president and director of bonds for Fidelity Investments, New York, who calls it “the storm before the calm.” Mr. Ramanathan, a former director of the Office of Debt Management at the Treasury Department, has experienced several debt ceiling dramas at close range, and sees no other option but for Congress to again raise the debt ceiling, which does not increase government spending, but allows the Treasury to pay for expenditures that Congress already approved. “Do we increase it by some specific number or some specific date? Those are really the two (possible) outcomes,” Mr. Ramanathan said.

Congress has raised or redefined the debt limit 78 separate times since 1960, noted Donald Marron, director of economic policy initiatives at the Urban Institute, Washington, and a former White House economic adviser. While congressional leaders in both parties know it has to be done, they “should avoid self-inflicted shocks” of waiting until the last minute, which could be economically and fiscally costly for a still recovering economy, Mr. Marron recently cautioned in testimony before the congressional Joint Economic Committee.

Technically reached in May

The $16.7 trillion federal debt limit was already technically reached in May. Since then, Treasury officials have resorted to extraordinary measures, including suspending allocations to the $160.3 billion Thrift Savings Plan's G Fund, and other civil service funds. Even with those efforts, by mid-October the federal government is expected to be down to its last $50 billion, which could easily be wiped out with one day's expenditures.

One of the biggest economic and political uncertainties came Sept. 17 from the non-partisan Congressional Budget Office, with a projection that the national debt will equal U.S. economic output in 25 years unless there are significant changes in fiscal policy. Even with continued budget sequestration, if the current spending resolution is extended and there are no economic consequences from a higher debt limit, CBO analysts say it still won't be enough to offset unchecked spending on entitlement programs, interest payments on the federal debt and inadequate tax revenues.

Those dire projections are being seen by some members of Congress as openings for discussions of tax reform or wholesale changes in entitlement programs like Medicare and Social Security. House Republicans plan to introduce tax overhaul priorities in their proposal for increasing the federal debt limit, and House Ways and Means Committee Chairman Dave Camp, R-Mich., has pledged to reduce the top corporate and personal tax rates to 25% from the current 35%.

Paying for those lower tax rates would put tax preferences for retirement contributions and other benefits under the microscope, along with the carried interest tax rate paid by alternative investment managers' general partners that is lower than income tax rates.

While retirement plan executives, plan providers and general partners are on guard, specific proposals have yet to emerge as the spending and debt ceiling debates continue, and there is little time in this congressional session for major tax reform.

Still, said one pension lobbyist, “We're worried that we could see some little things that could have a big impact.”

Economy is bigger story

For many observers, the bigger story is the improving U.S. economy, which will help mute any potential impact of the spending and debt crises on financial markets.

James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, is not too worried. “I think it's another thing that the markets have to go through,” along with Federal Reserve asset purchase tapering and re-pricing of the bond market.

“I was more concerned about bad short-term reactions (when) we had such skittish markets. Some of it is real fiscal improvement; maybe more of it is more psychological improvement. I think we've given up (our) Armageddon hypochondria,” Mr. Paulsen said. “A lot of this is written around the confidence level. It caused a re-pricing of everything because we decided the world wasn't going to end.”

Said Stephen Wood, chief market strategist for Russell Investments in New York: “There is a lot of brinksmanship.

“You need to understand that it's there and that there can be these exogenous shocks. If you're disciplined, focused and your strategic asset allocation is in place, that gets you through. You build in these long-term all-weather asset disciplines. We've found that when you've got these globally diversified multiasset strategies, volatility can be a useful tool,” Mr. Wood said. Like an NFL coach scripting out plays, “you want to have the scenario analytics done ahead, and then you step into the probabilities.”

Tim Barron, chief investment officer of investment consultant Segal Rogerscasey, Darien, Conn., sees the fiscal uncertainty as a good opportunity to have clients reassess their organizational missions and portfolios “and consider diversification to a level you may not have thought of before. Washington is one of the things on the list we talk to clients about, and causes us to redouble our efforts to re-evaluate our portfolios.”

Fidelity's Mr. Ramanathan expects that financial markets will start paying closer attention if the debt ceiling debate remains unresolved in October and the Treasury considers postponing some auctions. He is keeping an eye on whether the improving fiscal situation causes Treasury to further reduce the size of its debt issuance, after years of modest activity.

“People argue all the points they want to argue right down to the wire, and then they cave. You just have to abstract from the noise,” said Robert Tipp, managing director and chief investment strategist at Prudential Fixed Income, Newark, N.J., which manages $400 billion in assets.

“You stay tuned, but I think you go with the long term here, which is, rates have gone up, the economy is better, yields are back. You are not going to get a heightened sense of anxiety.”

Still, Mr. Barron of Segal Rogerscasey worries that continued brinksmanship and partisanship undermine the government's credibility.

“You can only go to the brink so many times,” Mr. Barron said. “The worst thing in the world is if the somewhat fragile recovery is held back because the U.S. can't get out of its own way.” n

This article originally appeared in the September 30, 2013 print issue as, "Budget, debt ceiling gridlock not worrying investors ... yet".