Stalemate in Washington

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. – Paul Samuelson

Although there was still no agreement by week’s end on either the budget or the debt ceiling, markets behaved like a deal had been reached as the S&P 500 jumped over 2% on Thursday and added to its gains on Friday. The mere fact that both sides were talking in this political battle of wills was considered cause for celebration. Investors, either rightly or wrongly, perceived these efforts to communicate as a positive sign that the politicians in Washington were serious about resolving these issues. A proposal to extend the debt ceiling deadline by six weeks was the latest plan designed to avert a debt default. The government has always been adept at kicking the can down the road when it comes to reducing our enormous debt. But even this plan ran into a snag over the weekend as talks broke down between the White House and House Republicans. That left it up to the Senate to craft a deal to end the deadlock and avoid breaching the debt ceiling. With the clock ticking and the two sides no closer to an agreement, it appears the market could be in for more volatility in the week ahead. While the odds of a first-ever default are slim, as Yogi Berra once said, the game isn’t over until it’s over. And it looks like this one may go down to the wire.

Last Week

As the government shutdown enters its third week, economists have begun to lower their GDP growth estimates for the fourth quarter, in some cases by as much as 0.5%. The longer that this stalemate continues without a solution, the bigger impact it will have on corporate profits as the uncertainty weighs on their decision-making for the future. While the beginning of earnings season last week was generally positive, the ongoing crisis in Washington overshadowed the profit reports and relegated them to a secondary role.

Janet Yellen, who was thought to be the odds-on favorite to succeed Ben Bernanke as the new Chairman of the Federal Reserve, was formally nominated for the position by President Obama. She will become the first female Fed chief and will likely continue the easy monetary policies put in place by her predecessor. The minutes of the September Fed meeting were also released and showed that most of the members agreed that more economic data should be reviewed before a decision is made to reduce the monthly bond purchases aimed at keeping interest rates at low levels.

For the week, the Dow Jones Industrial Average gained 1%, the S&P 500 Index added 0.8% and the Nasdaq slipped 0.4%.

This Week

All eyes will again be on Washington this week as lawmakers attempt to deal with the government shutdown and raising the debt ceiling. The importance on reaching an agreement on the ladder cannot be minimized. With a debt ceiling deal, there is a good chance that the market could rally into the year-end close. Without one, the effects of a default could be destabilizing and even devastating to the global economy.

If the government doesn’t open this week, economic data from the Labor and Commerce departments will be delayed. Industrial production for September is expected to be stronger than expected and a sign that the recovery in the manufacturing sector is for real. A number of companies are also expected to report third quarter earnings this week and will provide valuable clues about the likelihood of additional gains in the stock market. Among those companies reporting include Citigroup, Coca Cola, GE, Intel, Google, IBM, Verizon, Union Pacific and PepsiCo.

Portfolio Strategy

In the absence of government data over the past two weeks since the shutdown began, corporate earnings reports will likely take on added importance this week. Companies whose business depends on receiving government contracts could be affected by the paralysis in Washington. Only a few prominent companies kicked off the earnings season last week and their results were mixed. JP Morgan Chase reported a surprising quarterly loss due to a $9.2 billion charge for legal expenses while Wells Fargo reported weakness in mortgage lending, its bread and butter business. What these early reports portend is unclear but after this coming week is over, we should have a much better read on corporate profitability and earnings guidance going forward. With approximately seventy large cap companies scheduled to report third quarter earnings, investors should be able to gauge the health of the economy and its growth prospects. The industries of the companies that will report include banking and finance, consumer discretionary, consumer non-durables, health care, technology, retail and industrials. As important as the quality of earnings in the third quarter is management’s guidance on earnings growth in future quarters.

As turbulent as the stock market was last week and is expected to be this week until the debt ceiling is resolved, bonds have been a relative sea of calm. Since peaking at about 3% over a month ago, the yield on the 10-year Treasury note has fallen below 2.7%. With the Fed’s stimulus plans firmly in place until at least the end of the year and slower economic growth possible due to the government shutdown and sequester, bonds should provide a safe haven for investors. Since most people believe that a U.S. government default is out of the question, bonds should continue to do well and not be subject to the interest-rate risk that affected them during the summer.