"We are up to our knees in midgets when it comes to policymakers in Washington, D.C." - Michael Steinhardt
My explanation for the recent market's strength in the face of a possible U.S. debt default is twofold. First, there is still some time for a compromise to be made, and a compromise will be based on who blinks in the last hour of negotiations. Moreover, most market participants expect -- and I agree -- that the regulatory agencies will give our officials some slack and won't act prematurely. Second, there has been a lot of derisking into the Greek/eurozone sovereign debt fiasco and especially after the hedge fund community's woeful results in May and June (as an example, it has been reported that the Soros funds are 75% in cash). There has also been some summer exhaustion (probably caused by uncertainty and market volatility), and most of the larger funds have grown reluctant to trade on Washington headlines. Those funds have been caught "offside" in the recent market advance and are underinvested. This setup has softened any market blows based on the repeated failures in agreeing to a budget and debt ceiling increase.
In the fullness of time, it appears we will get tax and entitlement reform -- finally everyone realizes the soup we are in with fiscal imbalances (local, state and federal) out of control. (Unfortunately these headwinds will serve as significant growth deflators in the years ahead).
It always seems to take abject fear to get anything done in Washington. It happened three years ago with Secretary Paulson's $700 billion rescue package; there was little debate or analysis. The same thing is happening now. These proposals are being rammed through based on the same fear-mongering that occurred when Bear and Lehman failed. Daly and Boehner are even using the same terminology today -- our regulators again argued that a package must be prepared "before the Asian markets open." (I think these guys have read Sorkin's "Too Big to Fail" too many times.)
We continue to run policy based on how that policy impacts asset prices. QE2 was such an example, and so are this week's negotiations on the budget and debt ceiling. Something has happened to encourage scripted talking points and to discourage compromise between our two political parties; debate has become vitriolic and acidic.
A divided and dysfunctional government more concerned with those talking points than thoughtful policy has likely already brought much damage in the "aura" of the U.S. -- in our creditworthiness and in the perception of a lack of seriousness regarding a decisive attack on our fiscal imbalances. As well, investors have become like Dorothy in The Wizard of Oz when she discovered that the Wizard was only another human being. We investors have learned -- perhaps painfully over the last decade -- that our politicians are only human beings, mortals whose primary concern appears to be being re-elected.
Core concerns:
1. the continued secular headwinds to growth,
2. a general loss of confidence and
3. the increased recognition of the ineptitude and partisanship of our politicians, which has been vividly demonstrated and reinforced in the D.C. debt ceiling circus over the past several days.
Stated simply, the problems run deeper than the current debate, as evidenced by the absence of major deals and solutions on trade, jobs and other key issues.
