Last week, investors cheered that Washington managed to eke out a deal at the 11th hour. But despite any headlines to the contrary, the debt ceiling deal wasn’t all good news. Here’s a quick look at the good and bad news and its implications for investors.
The Good News
- One less major market risk. As I write in my new weekly commentary, last week’s last-minute debt ceiling deal was a positive for markets. It prevented the worst case outcome and removed a significant systemic risk.
- The Federal Reserve will err on the side of caution. And while the economy will slow a bit as a result of the recent drama in Washington, the Fed will recognize this and likely keep rates lower for longer. In addition, due to the soft housing market, the Fed will likely be more conservative in allowing rates to rise, focusing its tapering efforts first on Treasuries rather than on Mortgage-Backed Securities (MBS).
The Bad News
- The short-term deal solves nothing. While the deal did temporarily extend the debt ceiling and end the government shutdown, it didn’t solve the country’s long-term issues and the economy is still struggling. The market will face the same issues again in early 2014, at which point not much will have changed.
By most political metrics, such as voting records, both the House and the Senate are more polarized than they have been in at least a century. Given how far apart the two parties are philosophically, the type of short-term deal that was struck last week may become a template for what to expect over the next year, and potentially for the next three, if the political status quo holds after the 2014 mid-term elections.
And while the United States isn’t in danger of a recession, slower growth isn’t consistent with the continuous rise in US valuations. US stocks are now trading at roughly 2.5x book value, a 15% increase from the end of 2012.
So what does this mean for investors?
I expect that continued Fed accommodation will help support stocks, which look reasonable on a global basis, over the next six to 12 months. However, last week’s rally seems aggressive for a few reasons: All Congress could fashion was a temporary solution, economic growth remains soft and the Fed will likely start to taper at some point in the next six months or so.
In addition, though US stocks still look reasonable compared to their historic valuations, they are looking fully valued relative to an environment of 2% growth. Though I continue to see good bargains outside the United States, there are fewer bargains in the US market.
As such, I continue to advocate that investors consider raising their allocations to international equities, and within the US market, the energy and technology sectors appear to be more reasonably priced. Finally, given that I expect the Fed to implement a more conservative taper, I’m now advocating that investors overweight MBS relative to other fixed income instruments.