The broad stock market lost 6.66 percent of its value on Monday, as the demon of the U.S. credit downgrade stirred fears that fiscal restraint will destroy what remains of economic growth.
On Monday afternoon, President Barack Obama called for “a new sense of urgency” in addressing the deficit and the federal debt. That was, perhaps, just what Standard & Poor’s wanted to hear, but it spooked investors nonetheless.
As the markets absorbed the downgrade issued late Friday, the evidence suggested that the forces of fiscal restraint had the upper hand.
The S&P 500, down about 2.5 percent before the speech, lost almost 7 percent by the end of the session. And commodity prices fell, with the exception of gold and silver, which many investors view as a safe harbor in troubled times. The price of light sweet crude oil fell in New York to $81.67 a barrel, down $5.21, or 6.38 percent for the day. Everything from copper, to cotton, coffee and cattle futures fell as well, all signs that demand for raw materials may drop as the economy continues to slow down. The price of TIPS, an inflation-adjusted bond, dropped too.
The downgrade “is anti-growth as the U.S. becomes one of many nations that must think about what ratings agencies say: that is why TIPS break-evens are contracting today and inflation expectations are falling. So are many commodity prices,” wrote Jonathan Lewis, principal of Samson Capital Advisors, a New York–based asset manager that focuses on fixed income and has about $7 billion under management, in a note to clients.
While Treasury prices rose, driving the dollar higher, Lewis dismissed those gains as a “reflex action” that is unlikely to be sustained. Despite the U.S.’s new status as a AA+ creditor, at least in the view of S&P, the dollar retains its role as a safe haven and a global reserve currency, at least for now. Given the even greater turmoil in Europe, where the European Central Bank announced on Sunday that it would buy the debt of Spain and Italy to prevent the spread of the credit crisis in the euro zone, Treasury bills and dollars appeared relatively reassuring.
Over the longer run, the main question for the U.S. is whether policymakers, lawmakers and regulators will in fact approach the U.S.’s fiscal issues with greater urgency. A bipartisan “gang of six” Senators is working toward a compromise on budget issues, as is a “super committee” of Senate leaders. Although such compromise may satisfy deficit hawks, it is a cause of concern for some economists who view the lack of growth as the biggest problem facing the U.S. economy.
“My view during the debt ceiling debate was that the focus was misplaced,” says Josh Feinman, global chief economist for DB Advisors, the institutional asset management business of Deutsche Bank. “Our problem, in the short term, is growth, or the lack of it.”
The economy, which grew only 0.8 percent in the first half, won’t achieve his original target of 2.5 percent growth in the second half. “The economy is slowing,” says Feinman, who puts the odds of a recession at 25 to 33 percent. A second recession now, when unemployment is over 9 percent, would be a “disaster,” he adds.
Feinman says the U.S. needs to do what it can in the short run to boost growth, while focusing on longer-term strategies to get its fiscal problems under control. Over time, the U.S. can proceed with some sort of health care reform, raise the retirement age and boost revenue by imposing a gasoline tax, according to Feinman. He also thinks that tax reform — possibly closing some deductions while lowering marginal rates — would help address the longer term fiscal health of the nation.
Over the short term, the Fed can possibly boost its balance sheet, or sell its short-term holdings and buy longer term holdings to push long bond yields lower. There may not be much room to maneuver in these areas, but that is no reason to avoid taking the available steps, says Feinman. “I don’t see why we can’t be on a dual track,” he adds.
Feinman predicts that the “shock” of continued economic deterioration may force regulators and lawmakers to embrace growth-oriented policy. For now, however, the market seems to indicate that policymakers will turn their attention to austerity.
