US budget deal - cue for a return to the ‘risk-on’ trade
Mike Lenhoff – Chief Strategist
Brewin Dolphin
Investment Research
1 August 2011
Markets start the week probably more reconciled than before to the prospect that, even with an agreement on budget cuts and the extension of the debt ceiling, the US is still likely to lose its triple A credit rating. But importantly, they also start the week with a good deal of relief that congressional leaders have come round to a deal which, quite aside from providing a boost for Wall Street, could now boost confidence on main street, which would be good for growth.
Awaiting congressional approval is a two stage process of budget cuts worth $2.4 trillion spread over 10 years; initial ‘discretionary’ spending cuts of $917 billion would be followed by a further $1.5 trillion of cuts, backed by an enforcement mechanism, to be agreed before the end of November by a special 12-member congressional committee of Republicans and Democrats. The deal would allow President Obama to raise the debt ceiling by at least $2.1 trillion – initially by $900 billion – in stages that Congress would be most unlikely to block.
Whether US sovereign debt is any less vulnerable to a downgrade is another matter. Of course it depends on where or who you take your steer from but the budget cuts awaiting congressional approval are some way from the 4 trillion mark that S&P regards as a start in the direction for stabilizing the US government debt-to-GDP ratio. So will the prospect of America’s credit rating being lowered by a notch prevent a switch to the ‘risk-on’ trade?
Not if hammering out a budget and debt ceiling deal boosts confidence for the corporate sector, particularly for the smaller and mid sized companies, which create most of the jobs. If that happens, the non-farm payrolls, the latest for which is due on Friday, are likely to start improving again in the coming months and, with that, consumer confidence is very likely to pick up too.
We have made the point several times that, while equity markets have had every opportunity for a sell-off, they have been reluctant to cede much ground. Equity markets have gone nowhere at a time when the global recovery has lost momentum. Yet the earnings story is positive. In the US for example, where two thirds of the S&P 500 has now reported, the ratio of beats to misses on earnings is four to one and significantly, expectations for top line as well as bottom line growth for the quarter has been revised up.
Meanwhile yields in bond markets have continued to fall. In Value and earnings make equities a better buy than bonds, 25 July 2011, attention was drawn to the valuations for equity markets, noting that earnings yields were now even higher than yields on below investment grade corporate debt. Bond-equity earnings yield ratios are shown in the chart below for the life of the series available. With one exception, the ratios have not been lower and even for the one exception the ratio is still historically low.
It all suggests that relative to bond markets, be they inflation-linked or conventional government debt or high grade or high yield corporate debt, equity markets offer incomparable value for the life of the alternative series available.
What equity markets need is space to reflect on the fundamentals. The eurozone sovereign debt crisis has been crowding out that space but it should help matters if the momentum for implementing the framework established last month for dealing with Greece can be maintained. Whether equity markets come to feel burdened by the prospect of a downgrading in US sovereign debt remains to be seen but a US budget deal at least removes some of what has been troubling them and might even be a big enough deal to help equity markets return cautiously to the risk-on trade.
We have said before that what equity markets are looking for is an opportunity to move head. Despite a backdrop that remains fraught with risk, neither the S&P 500 nor the FTSE 100 has traded below their respective 200-day moving average this year, though this has not been the case with the eurozone indices. It is worth repeating too that, given their valuations, a shift out of the bond markets could help equity markets not only return to their previous highs but also take them higher.
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