Equities Catch-22

The U.S. fiscal deadlock appears not to have been resolved at the time of writing. This is an interesting Catch-22 situation for equity markets.

I think the most likely outcome for the budget and debt ceiling talks is that the U.S. will continue to muddle through without any major concessions by President Obama, after a "short" shutdown of 1-2 weeks. This should mean that the shutdown should largely be a non-event for the economy from a very macro level; growth is slow, and should just get marginally slower. (I do not think the shutdown by itself will be enough to trigger the inventory correction which appears to be the likely cause of the next U.S. recession. That said, the news flow from outside the U.S. poses greater risks.)

However, to get there, strong pressure will have to be put on the Republicans to compromise. It may be that the equity markets need to start falling with enough vigour to catch the attention of the party's financial backers.  But if you take a longer view, there is no reason for the equity markets to fall, since the impasse will be a non-event economically.

For a longer-term investor, it seems the only sensible policy is to do nothing special, and hope that the other investors panic. With the average holding period for equities now measured in milliseconds, it may be that there will be enough news-driven volatility to provide the short-term panic so that equities will end up OK in the longer-term.

My guess is the bond market will be watching this from the sidelines. The level of bond yields we are looking at do not pose enough interest to the public to put pressure on lawmakers one way or another. (For example, let's say the 10-year Treasury Note sold off to 3.5% on fears over potential default. That would be a very impressive move from the point of view of a fixed income analyst, but the broad public would rightly say, "So what? 3.5% is a very low interest rate.")
 
Turning to other legislative failures, the situation in Italy could be very important, but it appears that a crisis should be averted for now.

(c) Brian Romanchuk 2013