James Saft, Reuters Columnist
As if they weren’t already risk-eating zombies, investors are being further conditioned to close their eyes and buy.
House Republicans proposed a short-term plan to extend the US borrowing limit by six weeks, a move which would avert, at least for the time being, a default on US debt.
The deal, which would run through November 22, just before Thanksgiving, would not end the 10-day-old government shutdown, but would shelter the economy and financial markets from the carnage that a US default would bring.
That was enough to send the S&P 500 up by more than 2%, lead to a rally in the dollar and leave the Dow Jones industrial average just a few points below where it was before the shutdown began.
Of course, no one ever believed in a default. That was obvious from the way markets were trading beforehand. Really the only action was in short-term Treasuries, where money market funds were lightening up on US debt in order to avoid breaking the buck.
Virtually everyone else in the world without a compelling business or social reason to avoid small losses was acting, as they have been trained to, as if the trifling matter of the first default in more than 200 years was simply a bit of bad theatre.
Investment managers are, on the whole, neither paid or conditioned to be prudent. Quite the reverse
That is probably the correct analysis, but is not particularly comforting.
It ignores the possibility that some day, maybe even, oh, I don’t know, in November, the two sides won’t be able to reach an agreement and the US will, in some form, default.
For reasons well explained elsewhere, that would be a major disaster, and one centered in financial markets, where a series of defaults and forced sales would hammer all risk assets. It would also mean an instant recession, and probably a pretty deep one.
A relaxed attitude about the Washington follies also ignores the real harm being done on Main St. Polls from Gallup and Rasmussen show consumer confidence falling sharply. On Gallup’s measure, economic confidence fell by the most last week since the week after the collapse of Lehman Brothers in 2008. Does that sound like the backdrop for a mild loss in risk assets?
Pavlov’s (or Yellen’s) investors
To be sure, some of today’s rally was short covering, and perhaps we’ll see some losses tomorrow. And of course the deal is not yet done, and perhaps if it founders or is delayed investors will wake up to the risks.
I doubt it.
Investment managers are, on the whole, neither paid or conditioned to be prudent. Quite the reverse.
First off, a default is Armageddon, and as you may have heard, no-one survives Armageddon. That means that for money managers, who work against a benchmark, it is sort of meaningless. While Noah gets props for the ark, very few money managers lie awake at night fantasising about outperforming during a nuclear winter. It probably won’t come and they will all be out of luck if it does.
There may also be an element here in which the financial markets, filled with people who imagine themselves to be rational, can’t quite grasp the motivations of the true believers on the right wing of the Republican Party. They may see this as being a negotiation, which they do all the time, rather than a stand, something with which they may not be familiar.
There is also the fact that they have been, for more than a decade and a half, conditioned to expect the Fed and other authorities to pull their fat behinds from the fire. It started with Long-term Capital Management in 1997 and continued through the non-taper last month, which was partially justified as a means of providing insurance against the debt standoff. Time and again since 1997, it has been in money managers’ best interests to play the momentum game. To eat, rather than evaluate, risk.
And it is hard, at least in the short term, to go against this playbook.
The Fed certainly isn’t going to taper this month, and may well not do it at all this year, given not just Washington’s dysfunction, but the ongoing impact this will all have on the economy.
That means liquidity will remain ample, bonds will continue to be bought by the Fed and, by and large, junk will outperform quality.
As we have seen, that works until it doesn’t, and when it doesn’t it becomes someone else’s problem.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)