Bracing for a Beltway Bombshell 

Kristina Hooper 

The Upshot 

9/30/2013 

With Washington mired in a fiscal gridlock, investors need to be prepared for short-term volatility. But buying on the dip and boosting exposure to risk assets can keep their long-term goals from getting jammed up, says Kristina Hooper.
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Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

America’s political and debt problems are pretty bad. But investor fear could be worse.

The stock market eased lower last week as the possibility of a government shutdown increased with each passing day. Both political parties are refusing to blink just hours ahead of the deadline for a continuing resolution on fiscal spending. The conventional wisdom that an eleventh-hour deal would be reached appears to be slipping away. And we’re now facing a possible Beltway bombshell. Indeed, the Fed’s fears about “fiscal headwinds” may soon be realized.

In the short run, stocks are likely to continue to fall if no deal is struck today. But even if Congress can stave off a government shutdown, the debt limit is poised to be a bigger battle between Democrats and Republicans. Still, long-term investors should view the fiscal melee in Washington—and the market volatility that comes with it—as a buying opportunity.

What Me Worried


Given this difficult situation, there are a few things investors should be prepared for. First, the bad news:


Expect more volatility if there’s a government shutdown. We will likely have a significant negative reaction if a shutdown occurs because the market had not been expecting it as recently as last week. Consider that current credit default swap rates remain below what we saw during peaks in 2011 and 2012. Given that we’re on the brink of a government shutdown, current spreads suggest that investors are complacent and will be shocked by an actual shutdown.
The longer the shutdown, the higher the volatility. This crisis may not be over right away; it may take a few weeks—or longer—to reach an agreement given that the two sides are so far apart right now. And it may segue into a larger debate over the debt ceiling, since that is fast upon us. What’s more, we might not see a public outcry immediately that could pressure lawmakers into agreement. Why? Because a shutdown may not impact most people’s lives right away. In addition, Congress and the president still get paid even if there’s a government shutdown, removing one more incentive that could have led to a speedier resolution.
The debt-ceiling debate will amp up volatility even more. The stakes are higher in the debt-ceiling debate, as that would mean an automatic 4% cut in government spending. In addition, an impasse on the debt ceiling could threaten the US credit rating.

After all, much of this shutdown volatility will stem from the psychological impact on investors. Most investors still have a post-crisis mentality and are far more risk averse than they were before the Great Recession. In 2011, legislators’ failure to reach a consensus on the debt ceiling shattered investor confidence. Investors want to know that their legislators can work together to reach an agreement because there will be times when that’s a necessity, not a luxury, in ensuring our nation’s stability and security.


Now for the good news:


Financial conditions have loosened. The Fed’s decision not to taper its bond purchases has, in just a week and a half, moved the yield on the 10-year Treasury down to 2.62% and the 30-year fixed mortgage rate down to 4.28%. This should counteract, at least somewhat, a government shutdown.
Buy on the dip. Think of this period of uncertainty as a buying opportunity for those who are under-allocated to equities and have a long enough time horizon. Historically, shutdown selloffs have been short-lived. Despite the debt-ceiling debate and ensuing downgrade in 2011, which sent stocks plummeting, stocks soon recouped their losses and rallied further.


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Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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