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U.S. Debt Ceiling Suspension Impact

02/13/2014

Yesterday, the United States Senate voted 55-43, along party lines, to suspend the debt ceiling limit until March 15, 2015. This followed Tuesday’s congressional vote passing the legislation, 221-201. For months, I have emphasized that investors should not fear this situation or change portfolio strategies based on a potential August 2011-style debacle. With the upcoming 2014 mid-term elections, neither side could afford any D.C. discourse that would elevate market volatility.

Investors should view the suspension favorably over the long term. As I argued yesterday on CNBC, I suspect this was the catalyst for Tuesday’s strong advance for the S&P 500® Index (SPX). However, the impact of winter weather, emerging market volatility, upcoming Japanese consumption tax, and overall fund flows will continue to produce frustrating price action for risk assets in the near term.

From a longer-term perspective, heading into 2015, the perceived date for the debt ceiling deadline will be March 15. However, D.C. policy makers, markets, and possibly most importantly the Federal Reserve have more time than that. With the inclusion of the U.S. Treasury’s extraordinary measures, income tax payments, and government-sponsored enterprise (GSE) dividends, the deadline will most likely push into the final few months of 2015, possibly even the early months of 2016.

With the debt ceiling headwind pushed back to late 2015, or even early 2016, the FOMC can no longer cite “fiscal policy” concerns in statements or during testimony and speeches. Therefore, one less obstacle is removed from determining the pace at which the asset purchase program will end and when the FOMC will actually begin to raise interest rates. I expect that clarity is a good condition. Plain and simple, the FOMC will monitor pure economic growth in making its decision.

I expect that a much more dramatic growth contraction is needed to halt the taper process than is presently evident. Clearly, the momentum for accelerating U.S. growth has moderated in the first 45 days of 2014, but I applaud Goldman Sachs’ usage of “pothole” to describe the slowdown. Potholes slow down travel time as they are repaired, but they are only temporary. The asset purchase program will be wound down by year’s end and 2015 will follow with an investor focus on the first actual interest rate hike.

Lastly, as the dialogue centers on the growth slowdown and taper process, I would argue that 10-Year Treasury yields have traded to exactly where those seeking a benign outcome to tapering wanted. Remember the conversation about once the FOMC began to taper, yields would rise and the Fed would lose control of the bond market? Not so fast. On the afternoon of December 18, when tapering was finally announced, the yield on the U.S. 10-Year Treasury (Figure 1) traded at 2.89%; this morning it is trading at 2.75%. This is clear evidence that the Fed is not losing any control of the bond market and that the cost of capital remains incredibly favorable for U.S. corporations. While we’re on the subject of U.S. corporations, let’s update our earnings table (Figure 2) as well as the all-important profit margin chart (Figure 3).

Figure 1: U.S. 10-Year Treasury Yield, December 2013 to Present

Source: Bloomberg

Figure 2: SPX EPS and Revenue Growth, as of February 13, 2014

Sector

Reported

Yet to Report

Sales Growth

EPS Growth

Overall SPX

388

111

0.92 %

9.02 %

Consumer Discretionary

53

31

6.57 %

13.52 %

Materials

27

4

2.81 %

30.60 %

Utilities

14

16

3.05 %

-0.48%

Technology

59

6

5.32 %

7.37 %

Telecom

4

2

2.49 %

27.26 %

Industrials

54

9

2.45 %

16.76 %

Consumer Staples

30

10

2.70 %

4.54 %

Health Care

46

8

5.81 %

2.52 %

Financials

72

9

-10.65%

20.59 %

Energy

29

16

-3.05%

-9.53%

Source: Bloomberg

Figure 3: SPX Profit Margin (Currently 9.43%)

Source: Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.