US debt ceiling looms

[Rock Private Office]

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In many ways the US appears to have judged the recovery right. Its economy has emerged stronger and faster from recession than any other, and its banking system and housing markets are – by and large – mended. Superficially at least, it is possible to justify the relatively high valuations for US stocks. Yet as it careers into another political gridlock over the debt ceiling, does the US market still hold value for investors?

Global stock markets have ground to a halt as the Republicans and Democrats fail, once again, to reach agreement on raising the debt ceiling. This has countered the potentially positive effect of Ben Bernanke delaying the paring back of quantitative easing until late 2013/early 2014.

The Republicans again have Obama’s Government over a barrel on policy. In this case, the Tea Party wing of the Republican Party is using the debt ceiling as a means to stall elements of Obamacare. Gary Dugan, chief investment officer of Europe and Asia at Coutts says: “The Republican-controlled House of Representatives has made extending the debt limit conditional on a one-year delay to funding significant portions of the Affordable Care Act, a condition the Democrat-controlled Senate has said it will reject.”

The consequences of a failure to reach agreement are significant. Congressional agreement is required for all non-essential government spending for the new tax year, which begins on 1 October. Dugan says: “If compromise isn’t reached by midnight tonight, government departments may not have enough cash on hand to keep the lights on. The government is expected to completely run out of cash on 17 October, and be unable to pay its workers.”

This sounds familiar. It feels like a relatively short amount of time since the US was last in this particular predicament. In 2011, negotiations over the debt ceiling also went to the wire. No-one was surprised when agreement was finally reached, but politicians left it late and both the republicans and President Obama saw falls in their approval ratings as a result. In the meantime markets were left on tenterhooks, only to recover rapidly shortly afterwards.

In the end, the political machinations will probably play out in a similar way. Politicians will perform an elaborate game of chicken and end up with a five-minutes-to-midnight agreement.

But it may be a little different for stock markets this time. At the moment, they are vacillating nervously, but the real trouble for investors is that at the time of the last debt ceiling negotiations, the S&P 500 was trading in a range between 1200 and 1300, now it is at 1691.75 and has risen 20% this year, despite an expectation of full year earnings growth of just 5%. Dugan at Coutts points out that the last time there was a significant risk of a government shutdown in 2011, equities sold off while bonds held their ground.

Dugan concludes that US equities are significantly over-valued. Certainly the contrast with other geographic regions is marked: The US S&P 500 index is currently trading at 17.5x earnings. This is far higher than both other developed markets - the UK at 14.6x earnings and the German Dax 30 at 14.1x – and, in particular, Asian and emerging markets - the Hang Seng is at 10.9x earnings, the Chinese market at 7.2x earnings and the Russian market at 6x earnings. The US may be doing better economically than some of these other countries, but not that much better.

Perhaps the most stark contrast is with Germany, where political continuity and stability marked Angela Merkel’s re-election. No-one would suggest that the Eurozone is suddenly a haven of political tranquillity, but the stock markets still reflect political peace in the US, and storms in Europe. Some re-alignment of opinion is surely overdue.