However, the real game-changer for equity investors was the decision by the European Central Bank (ECB) in the summer of 2012 to finally agree to launch its bond bazooka and offer to use its massive balance sheet to purchase government bonds from the southern Mediterranean block of countries in order to stop the region's debt contagion spreading any further. This policy decision, albeit belated, had bond bears running for cover and resulted in the subsequent dramatic fall in secondary market yields in the government bonds of all the Southern Med block countries. As a result, a significant amount of risk embedded in equity market valuations due to a potential break up of the eurozone was removed. Add to that the US Central Bank’s largesse of purchasing an aggregate $85bn (£53bn) of Treasuries and mortgage-backed securities a month as part of its ongoing QE3 bond buying programme, the consequence of which is to drive investors to higher risk and higher yielding assets including equities, and the back drop for global stock markets in the western world has been incredibly benign.
Not that equity markets move up in a straight line, they never do as bull markets are habitually punctuated by corrections some of which can be severe. But the key point to note is that the pull backs are buying opportunities unless of course you think the great bull market of 2009 to 2013 has now run its course. I don’t take that view which is why I have continued to produce numerous buy recommendations on shares all year and have used pull-backs in the watchlist of my companies as repeat buying opportunities - a strategy that has served us incredibly well.
That’s one reason why I have issued no fewer than 253 buy recommendations in the past year (‘Simon Thompson’s buy recommendations’, 2 October 2013). It also means that the vast majority of readers who follow my articles will have been well served by the constant flow of updates on these companies in this time. I will endeavour to do the same in the future although it is worth noting that I will only issue an update once I have had the time to do my own due diligence and reassess the investment case. I think that the vast majority of readers understand that there is a vast amount of research I put into these share recommendations and I do not issue them at will.
I also try and assess the macro back drop before making any share recommendation as the asset allocation decision to continue recommending small-cap shares has to be right in the first place, before I start the extensive task of drilling down and uncovering the small cap gems hidden in the lower end of the stock market.
So, with this in mind, I can not ignore the impending deadline of Thursday 17, October for a resolution to the US debt ceiling.
Debt ceiling deadline imminent
As the deadline for resolution of the US debt ceiling approaches the positions of both parties in Congress seems to have become more entrenched. Unless the $16.7 trillion debt ceiling is raised by that date, the US administration will have just $30bn in its coffers, half of which is needed to cover expenses over subsequent days. Monthly tax revenues only cover two thirds of federal spending at this time of the year, making a default inevitable.
It goes without saying that failure to reach an agreement would send shock waves through financial markets and lead to a sequence of events that would result in a widespread increase in risk premiums. Clearly, this would have negative implications for equity markets as part of the fall in risk premiums we have enjoyed in the past 18 months would be reversed and investors would demand a higher level of future returns embedded in the price they are willing to hold equities. A savage sell-off in all risk assets would entail across the board.
I am far from complacent because although something may appear unimaginable, that does not mean that it can not happen. However, it is worth considering the political implications in the US if a default were to take place and consider whether this will be a deciding factor in an eleventh hour resolution being be reached. Clearly, president Obama appears willing to defend his domestic health care policy at all costs, a fact that the Republicans are undoubtedly well aware of by now. They will also be aware that they will be blamed by the electorate for the negative fall-out if the ceiling is not raised. This would be political suicide for the party ahead of the 2014 Congressional elections. Moreover, a number of Republican Congressmen have stated they would be willing to vote with the Democrats in the national interest, implying that the impasse may not be as wide as the headline makers try to make us believe. It would be in their own interest too.
Also, there is real possibility that the focus could shift away from Obama care towards entitlement and tax reform where a compromise between the two parties could be reached more easily. In this scenario, I would expect a short-term extension of the debt ceiling to buy more time for the political wrangling to unfold in the coming weeks and ultimately for the debt ceiling to be lifted.
Ultimately, the fall-out from a default by the US on its debt mountain is not just confined to the financial markets, a point that all politicians realise. It would stop the country’s economic recovery in its tracks and would make the current government shutdown, which has led to 800,000 non-essential staff being sent home, look like a drop in the ocean.
Given the US consumer accounts for the best part of 70 per cent of GDP, then the potential for a default to force the country back into recession is obvious as the administration would have no alternative but to make savage cuts in an attempt to balance its books. A sizeable segment of consumers would also have to reign in spending across the board. Economists estimate that the fiscal retrenchment required would be the equivalent of 9 per cent of GDP and would lead to a sharp economic downturn. It would also be one that the finger of blame would be squarely pointed in the direction of the Republicans.
Financial engineering could rescue the US
Although it may not have been mentioned yet, there is also the possibility that the US Treasury will continue to issue debt above the current debt ceiling after 17 October, which it could justify on the basis that a default would violate the 14th Amendment of the US Constitution. The downside of this is that bonds issued would carry a much higher default risk - and so higher yield - which would have implications for asset pricing across the globe.
Alternatively, the US Treasury could fund its funding shortfall through an overdraft facility at the Federal Reserve - unheard of, but a possibility nonetheless. It could even go one stage further and print a multi-billion dollar coin and deposit it at the Fed in order to raise the cash to meet its funding shortfall. That may be imaginable too, but it could happen especially as outgoing Fed Chairman Ben Bernanke would make history as the man who saved the US, not once but twice.
Ultimately, I feel the political fall out I have outlined above from letting the impasse in Congress continue beyond 17 October debt ceiling deadline is so huge that an eleventh hour agreement will be reached next week. A Gallup poll this week showed backing for Republicans has dropped to 28 per cent - its lowest level since the survey began in 1992, and down from 38 per cent a month ago. Backing for the Democrats is also down, but by only four percentage points to 43 per cent. In other words, the electorate are already reacting and they are blaming the Republicans for the impasse.
However, if an agreement is not reached in time, it will be time to fasten your seat belts, but be ready to opportunistically pick up bargains in the fall-out, which is likely to be short-lived. A sharp drop in the Dow Jones Industrial Average would clearly focus the mind of politicians and the damage they will be causing. Let’s just hope that common sense prevails and it doesn’t come to that. Either way, I am still on the look out for stock market bargains and my strategy is to use any market correction as a buying opportunity especially as the consequence of any market turmoil is likely to delay the start of tapering of the Federal Reserve's money printing programmes. And that would be good for equities once the dust settles.
