Spending cuts and the debt ceiling: Considerations for investors

When the U.S. Congress reached an 11th hour compromise on the fiscal cliff in early January, it settled many questions about taxes but kicked the question of spending cuts, known as sequestration, down the road—guaranteeing another pitched battle in Congress in just a few weeks. And, of course, the fiscal cliff deal did not address the issue of raising the debt ceiling.

According to Timothy Hopper, managing director and chief economist at TIAA-CREF, even a worst-case scenario for spending cuts won’t send the economy into a recession. More troubling is the debt ceiling debate. In this Q&A, he discusses the likelihood of an agreement, the potential consequences of a failure to compromise, and considerations for investors in the coming months.

What will happen in the next round of negotiations?

TIMOTHY HOPPER: There are two elements of the next round: the issue of spending cuts, or sequestration, and raising the debt ceiling. President Obama signed a bill February 4 to temporarily suspend the debt limit until May 18 to give Congress time to work on a budget that will address spending issues. Let’s look at the spending issue first. The worst-case scenario is $86 billion in spending cuts, half from defense and half from non-defense. We estimate this would shave a little less than 1% off of GDP in 2013, which we expect to otherwise grow in the 2%-3% range. So even in a worst-case scenario the economy is still going to grow. We’re not going to tip into recession.

What about the debt ceiling debate?

If Congress doesn’t raise the debt ceiling and we actually have a technical default, it would be a very tumultuous event. To pay its bills the government would have to cut spending elsewhere—perhaps by furloughing employees and cutting government programs. The ratings agencies would also downgrade U.S. sovereign debt, as well as every institution in the U.S. since no company can have a credit rating higher than the government of the country in which it is based. So the borrowing costs of every institution would increase. This is a dangerous scenario, but fortunately it’s not the one we expect. Our expectation is that Congress will come to an agreement at the last minute, or perhaps go over the deadline slightly just as it did during the fiscal cliff negotiations.

Would an 11th hour deal avert a ratings downgrade?

A downgrade is still possible. Fitch recently warned that it may put the U.S. on negative watch—which is the step before an actual downgrade—if lawmakers are forced to prioritize debt payments over other government obligations such as Social Security. It also warned it may take action even if lawmakers raise the debt ceiling but fail to take steps to lighten the U.S. debt load. These statements need to be taken seriously, but we don’t believe the ratings agencies will actually downgrade the debt. The most likely action is that Moody’s and Fitch put the government on negative watch.

How will the markets respond?

Given our view that spending cuts in 2013 will likely be minimal, the debt ceiling will be raised, and the sovereign debt rating unchanged, we believe that the financial markets will behave well this year, particularly equities. There are always caveats, of course, but earnings expectations are already improving from last quarter, which bodes well for stock performance in 2013.

Is the outlook as good for bonds?

Think of 2013 and 2014 as transition years. We’ve been in a very long, very low-interest-rate environment but we’re at the start of a transition to a different part of the economic cycle with higher interest rates. We’re at the very beginning of this and individuals need to plan accordingly since rising rates will lower the value of existing bonds in their portfolios.

What else should investors be thinking about?

The market’s expectation is that Congress will strike a deal on spending and the debt ceiling. The downside to this confidence is that the negative consequences will be severe if an agreement is not reached on time. In other words, the markets have not priced in a downside scenario as they did leading up to the fiscal cliff. So there would be further to fall. Ultimately, I do think it will be resolved, but investors should be aware of this dynamic.

So is it fair to characterize your outlook for 2013 as positive?

Yes. The economy is improving and growth is broad-based. It’s still modest, partially because of the uncertainty created by Washington. But we are out of recession territory from a fundamental perspective. Transportation and auto sales are having a positive ripple effect in production lines, metals and the steel industry. I think we will see improvements in job growth and incomes, which will boost demand for consumer goods across the board, drive corporate earnings and elevate stock prices.

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