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Market Extra: Washington policy turmoil begins to ‘migrate into the markets’ — What investors need to know

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The potential for another white-knuckle flirtation with default by the U.S. government via a debt-ceiling showdown is helping to raise “policy uncertainty,” analysts noted Wednesday.

The good news is that rising uncertainty has traditionally been a buying opportunity, according to a top Wall Street technician.

“We are believers that this will prove a buyable correction within an uptrend, but we don’t see the wild card being China, rather we see it as Washington,” wrote Jeff deGraaf, founder of Renaissance Macro Research, in a note.

Worries about a potential default by China property giant Evergrande triggered a sharp stock-market selloff on Monday. Those concerns have faded, with investors less worried about potential spillovers that could threaten the Chinese or global financial system.

Stocks were up sharply Wednesday, with the S&P 500
SPX,
+1.00%

up 1.2% and the Dow Jones Industrial Average
DJIA,
+1.12%

rising around 440 points, or 1.3%, ahead of a Federal Reserve policy decision due at 2 p.m. Eastern. Stocks were attempting to shake a so-far modest retreat that’s seen the S&P 500
SPX,
+1.00%

pull back 4% from its record close on Sept. 2.

Read: Will Evergrande be China’s ‘Lehman moment’? Wall Street says no

Renaissance Macro Research

DeGraaf highlighted the chart above, tracking the U.S. Economic Policy Uncertainty Index, devised by economists Scott Baker of Northwestern University, Nick Bloom of Stanford University and Steven Davis of the University of Chicago. It draws on search results from 10 large U.S. newspapers, reports by the Congressional Budget Office that compile tax code provisions due to expire over the next 10 years, and the Philadelphia Fed’s survey of professional forecasters.

While policy uncertainty “has started to migrate into the markets, politicians
will often take things to the edge to see who blinks and gain the upper hand,” he wrote.

While worries over a potential government shutdown in October and the debt ceiling are front and center, uncertainty is also on the rise over President Joe Biden’s agenda, including his infrastructure and social welfare spending proposals.

Renaissance Macro Research sees Republicans in Congress holding the stronger cards, which may allow them to force the issue, deGraaf said, noting that the index hasn’t yet jumped into the top decile (see bottom part of chart), which is typically a bullish signal when it comes to forward returns for the S&P 500 index.

“If your hands are strong enough to hold on, there are plenty of green lights to get the wheels turning, but don’t be surprised to see more planted leaks and adverse headlines before it’s resolved,” he said.

Outside the Box: Evergrande crisis and the U.S. debt-ceiling showdown could give stock investors a buying opportunity

The Democratic-controlled House late Tuesday approved legislation that would keep the government funded, suspend the federal debt limit and provide disaster and refugee aid, setting up a showdown with Senate Republicans who oppose the package.

The federal government will face a shutdown on Sept. 30, the end of the fiscal year, if a funding measure isn’t approved. A more dire threat surrounds the debt ceiling, which the government could hit at some point in October unless it is raised or suspended. Failure to act risks a U.S. default on its debt.

At least 10 Senate Republicans would need to vote in favor of the measure for it to get the required supermajority. Senate Minority Leader Mitch McConnell of Kentucky, the chamber’s top Republican, has insisted the debt ceiling be raised solely with Democratic support, citing opposition to a proposed $3.5 trillion spending plan.

Democrats have refused to attach a raise in the debt ceiling to that spending plan, which they intend to push through the Senate using a process known as reconciliation, which requires a simple majority. Top Democrats have insisted that lifting the debt limit must be a bipartisan undertaking.

A move to lift or suspend the debt ceiling, averting a potential default, remains the base expectation, but fears that legislative brinkmanship could result in a mishap are on the rise.

Economists at Moody’s Analytics warned Tuesday that a default would result in long-term harm to the economy and create chaos in global financial markets.

The Tell: Washington is ‘playing a dangerous game with the debt limit,’ and ‘Americans would pay for default for generations, says Moody’s Zandi

Meanwhile, memories of the last two debt-ceiling showdowns, in 2011 and 2013, remain fresh. The 2011 crisis saw Standard & Poor’s, for the first time ever, downgrade the long-term U.S. credit rating from AAA to AA+.

Another downgrade can’t be ruled out, even if the U.S. Treasury Department avoids a default but fails to honor other obligations, wrote economists at Oxford Economics, in a Wednesday note. They recalled that the 2011 episode also saw spike in volatility, as measured by the Cboe Volatility Index
VIX,
-11.21%
,
and a 10% drop in stock prices, though both shocks were rapidly reversed once the debt ceiling was lifted.

Still, investors “cannot discount the uncertainty factor and the knock-on effects on private sector activity,” they wrote.

Jitters are already apparent in the market for short-term Treasury bills, with rates rising on bills due to mature in the second half of October, analysts noted.

Worries about a potential government shutdown and the debt limit might also cloud deliberations by Federal Reserve policy makers, who are set to conclude a two-day policy meeting Wednesday afternoon. Investors will be looking for clues to when the Fed will begin scaling back its monthly bond purchases.

The Fed will release a policy statement at 2 p.m. Eastern, followed by Chairman Jerome Powell’s news conference at 2:30 p.m.

“We think Chairman Jerome Powell will have to maintain his dovish stance, stating that tapering is coming, but staying vague on the details,” said Greg Valliere, chief U.S. policy strategist at AGF Investments.

“In a world without government shutdowns and threats of debt default, tapering by late fall would be certain, but until there’s clarity on fiscal policy, the Fed may have to wait,” he said, in a Wednesday note.

Read: With Fed officials split over outlook, Powell seeks to find compromise tapering plan

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