There’s a lot of economic data floating around right now, providing mixed signals on growth or prolonged stagnation, but really, we don’t care all that much. The story that matters to us right now is the debt ceiling. Dreams of glittering trillion dollar coins aside, the U.S. is set to hit the debt ceiling mid-February. And as it stands, there are enough factors combining to make us very anxious about what that means for the market.
Exhibit A: They won’t raise the debt ceiling in time. No way.
President Obama held the last press conference of his first term today, tackling a wide variety of issues. The debt ceiling, however, dominated the talks. Obama made it very clear that he would not be negotiating spending cuts to convince Republicans to raise the ceiling in time:
Republicans in Congress have two choices here. They can act responsibly, and pay America’s bills, or they can act irresponsibly and put America through another economic crisis. But they will not collect a ransom in exchange for not crashing the American economy. The financial well-being of the American people is not leverage to be used. The full faith and credit of the United States of America is not a bargaining chip. And they better choose quickly, because time is running short.
When pushed about “alternate” options, Obama made it clear that there would be no workarounds or loopholes. Congress would have to do its job. The problem is that Congress doesn’t appear to be interested in that. In fact, despite the dire consequences that could come about if the debt ceiling is not passed, many Republicans on the Hill believe that burgeoning U.S. debt is so tremendous a threat that the short-term pain that would accompany failure to raise the debt ceiling is more than worth it. Politico reports:
The conventional wisdom is that Obama and Congress will ultimately work out a grand spending compromise that raises the debt limit, keeps funding the government and changes the $1.2 trillion in automatic “sequestration” spending cuts set to kick in on March 1.
Here’s the problem with that: Two top GOP officials told us Republicans are not willing to compromise on the $1.2 trillion in cuts. [...] GOP officials said 90 percent of their members are prepared to allow the cuts to take effect, rather than compromise, based on their preliminary head counts. This seems like the most likely outcome right now.
In other words, unless something radically changes in the Republican party over the next month, or Obama backs off of his refusal to negotiate, we’re going to hit the debt ceiling. But how much will it hurt?
Exhibit B: The Sequel is Always Worse than the Original…
We’ve done this song and dance before – in July of 2011, to be exact. What happened back then?
In 2011, the markets trucked along throughout June and July, with the general assumption being that there was no way elected officials would allow the creditworthiness of America to come into question. The ceiling, however, was hit on July 22nd, at which point the markets began a two week nosedive that extended several days past the eventual extension of the debt ceiling. The reason this matters is because what happens when you overlap market movement so far in the encore with the performance seen in the 2011 rendition. The market, since the emergency deal was struck on January 2nd, has been fairly sideways moving toward the debt ceiling deadline, standing in contrast with the 2011 upward slope:
Does today’s sideways movement indicate less faith in the government to do the right thing? Is it a function of lower average volume during the time period? We’ve got about a month to find out.
Exhibit C: Hedge Fund Bravado is Back to Pre-Crisis Levels
We make no secret of our disdain for the traditional hedge fund around these parts, but one of the things we do pay attention to in their realm is how confident hedge fund managers, in the aggregate, are about the direction of the market. We’ve been watching reports trickle in about hedge funds getting longer and longer, but nothing says confidence like leveraging things up a notch… or 20. Bloomberg reports:
Leverage among managers who speculate on rising and falling shares climbed to the highest level to start any year since at least 2004, according to data compiled by Morgan Stanley. Margin debt at NYSE firms rose in November to the most since February 2008, data from NYSE Euronext show.
The rising use of borrowed money shows that everyone from the biggest firms to individuals is willing to take more risks after missing the rewards of the bull market that began in 2009. While leverage means bigger losses should stocks decline, investors are betting that record earnings and valuations 9.8 percent below the six-decade average will help push the Standard & Poor’s 500 Index toward the record it set in October 2007.
“The first step of increasing risk is just going long, the second part of that is levering up in order to go longer,” James Dunigan, who helps oversee $112 billion as chief investment officer in Philadelphia for PNC Wealth Management, said in a Jan. 8 telephone interview. “Leverage increasing in the hedge-fund area suggests they’re now getting on board.”
It’s not the use of leverage that’s disconcerting here. It’s the comparison by date. Leverage is at the highest it’s been since February 2008 – as in, right before everything went to hell in a hurry. In a world where hitting the debt ceiling could cause a sudden and swift reversal (as it has in the past), these hedge funds are now setting themselves up to get backhanded by a risk off reversal.
In other words…
There are a few conclusions to be drawn here:
1. For those in the back – most hedge funds are souped up stock investments, and not likely to provide an alternative return stream in time of crisis.
2. We’re really glad we’re in an asset class that can still profit if the stock market falls – even if there are no guarantees it will.
3. The debt ceiling debate, with its political gamesmanship, could be a game changer for the 2013 market trajectory.
There are a lot of moving pieces in this scenario, and it could change at any moment. While we typically don’t mind a downward trend, we’re not rooting for one this time around… if only because we’re hoping that Congress rises above the hostage taking strategy they’ve embraced in the past, and proves to us all that the 113th Congress is not going to be a repeat of the 112th.