Here we are, just two working days away form Armageddon and despite constant assurances from politicians and Wall Street alike, there is still no deal in sight.
“Don’t panic,” they tell us, “a compromise could still be salvaged even if comes an hour before the August 2 deadline.
Given that the stock market has been discounting the possibility of a debt default all week, some of the potential damage is already in the market. The S&P 500 Index has declined just over 3% for the week. I estimated a default would cost the market 5-10%
As I watched the levels of the markets this week, it was clear to me that traders were buying the dips. As indexes reached certain technical price supports, they bounced in a textbook perfect manner. That says to me that Wall Street is not expecting a rout but rather the opposite, a big upside move once Washington gets its act together.
I also realize that this is a consensus view held by just about everyone. As a contrarian, that worries me. Remember, it has been the consensus view for well over a month that a deal would come together “shortly”. I disagreed, believing that an agreement would be delayed until the eleventh hour. I’m not expecting a deal over the weekend and neither should you.
As for the expectation that the market will rally after a deal, I will give that view the benefit of the doubt, but we will likely fall to the S&P 200 day moving average at 1,284 (just 10 points away) or possibly a little lower before this decline is over. The upside could be quite substantial, so hang on and enjoy your winnings.
What if everyone is wrong? What happens if the country defaults? I think we drop to 1,225 on the S&P and then bounce substantially from there. Yet none of the above really worries me. The market has been in a trading range for months and this is simply an extension of that pattern.
It is the Commerce Department’s second quarter GDP number that has me spooked. It came in at 1.3%. I (and most economists), were looking for 1.7%. At the same time, the first quarter number was revised down to just 0.4%. That raises a red flag for me. Those numbers are dreadful, despite the knowledge that Japan’s problems may have accounted for a sizable portion of that slowdown.
Think back a moment to what was supposed to happen in this economic recovery. The Federal government used the stimulus plan to supposedly jump start the economy while the Federal Reserve made borrowing so cheap that the banks and other institutions would be motivated to pass that money along to consumers and small business in the form of loans.
At some point (about now), the bet was that the private sector would pick up the baton and start investing, hiring and lending on its own, thereby engineering a long lasting recovery. That isn’t happening. What we have instead is a private sector that still refuses to lend or hire, leaving only one source of future economic growth on the horizon—additional government spending, plus whatever tricks the Fed can pull out of its hat.
It seems to me that beyond all the rhetoric in the capital, both parties are coming down on the side of cutting spending and possibly raising taxes. I think the first reaction to that move will be a relief rally. It’s the aftermath that worries me. After all, if we take away the single engine of growth in the economy (federal, state and local government) by cutting spending, what is left to drive the economy? Don’t count on consumer spending, which historically accounted for 70% of the nation’s growth. The consumer continues to de-leverage either winningly or by force of circumstances.
So it appears we are between a rock and a hard place. We can de-leverage the country by cutting spending, raising taxes and bearing the risk of another recession, or we can continue to spend and inflate until either the private sector picks up the slack or the whole house of cards comes tumbling down. Is there a middle way? Unfortunately we have been treading on that path for the last two years but it doesn’t seem to be working.
Let’s hope next quarter’s GDP brings an upside surprise. We need it.