Why stasis on Capitol Hill should worry investors

November 23, 2011

By Kathleen Brooks. The opinions expressed are her own.

The markets have had to – grudgingly – get used to pricing in political risk in recent months. Instead of being moved by economic data and fundamental or technical factors, a large amount of recent price action has been driven by politicians, and that always spells bad news.

Firstly, we have had to listen to the machinations of Europe’s various branches of power as they try to muddle through to a solution to the euro zone debt crisis. This has done very little apart from cause excess amounts of volatility in the markets as politicians talk at odds to each other. The results are pathetic: more than 18 months since the Greek crisis first flared up not only is Athens still deep in its own sovereign crisis but contagion has spread to Italy and Spain and even threatens to engulf some of the core member states like France.

Although most of the focus has been on Europe, the spotlight may shift to the U.S. Republicans and Democrats have failed to agree on $1.3 trillion of cuts to the Federal Budget, which makes it unlikely that the bi-partisan Deficit Committee can come reach a debt deal by Wednesday’s deadline. The problem isn’t the cuts: if Congress can’t agree where the axe can fall then automatic cuts will be enforced. The problem isn’t even the repercussions of missing the deadline: these cuts wouldn’t be imposed until January 2013 and the missed deadline will not cause a default on U.S. debt or a government shut-down, unlike the impasse in Washington back in August.

Instead this suggests that the U.S. and Europe are in a chronic state of political partisanship. In the U.S. its two main political parties are pitted against each other and in the currency bloc the same thing occurs with inflation and austerity hawks in the North failing to bow to pressure to implement policies that could boost the financially weakened Southern states. Essentially the political stalemate is a bit like blocked plumbing since it disrupts the normal flow of things, which damages investor confidence and has the power to cause excess market volatility and a prolonged slump in the global economy.

Thus, the political impasse in the U.S. coming at the same time as outright political dysfunction in Europe is important for two reasons. Firstly, Presidential elections don’t take place for another 12 months in the U.S. so there could be more political brinkmanship and bi-partisan bickering for some time. This is likely to undermine risk sentiment even further since it shows a lack of fiscal resolve in the U.S., which creates uncertainty – and the markets hate uncertainty.  Secondly, the bitter dispute regarding deficit cuts has turned ideological, which could impact growth going forward.

Republicans want spending cuts and Democrats want to increase taxes for the wealthiest Americans to boost the revenue side of the U.S.’s enormous balance sheet. This is important since it makes an extension of the payrolls tax cut and emergency unemployment benefits much less straight forward. Both of these expire at the end of the year and are considered important to boost growth: payroll tax cuts help to encourage firms to hire and unemployment benefits can keep consumption levels stable during periods of high unemployment.

After a summer lull, the U.S. economy is starting to show signs of strength. Even the unemployment rate is showing signs of improvement with jobless claims falling in recent weeks. If these two pillars of the U.S. economic recovery are removed at this critical juncture we could see growth back in the doldrums.

The ironic thing is that the pick-up in growth since the summer has actually made it more likely that the U.S. can pay its debts back. But if political wrangling hurts business and consumer confidence going forward then it also inadvertently hurts the country’s credit-worthiness. When politicians get involved the markets need to watch out.

 

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