Waddell & Reed

Market Perspectives

Improving economic outlook requires clear policy leadership

Story Highlights

  • Studies have shown that Congress is more divided now than at any time in recent history.
  • Despite the disagreements, we still believe U.S. economic growth is set to improve.
  • We also think the global economic outlook should improve further as we head into 2014.
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Investment Team

Manager Name

Derrick Hamilton

Vice President, Global Economist

We have consistently cited our concerns about a lack of government leadership globally, and particularly in the U.S., as an ongoing issue for the economic and market outlook. Recent policy events in the U.S. have further highlighted this issue as a key risk.

Washington roadblock

We have written many times about what we consider a lack of global leadership. We think this is a fundamental problem in the global economic outlook because continued indecision and infighting among policy makers weigh on market and consumer confidence. In our view, the situation also results in a lack of clarity for eventual decision making.

The focus recently has shifted to the U.S., where politicians in Washington, D.C. continue to cause anxiety in financial markets. Less than a year ago, markets were jolted by concerns about the “fiscal cliff” of spending and tax issues. Now there is another battle, this time about the fiscal 2014 budget and an increase in the debt ceiling. While these issues are important to debate, the brinksmanship makes us wonder why the country has these repeated policy crises. Why do U.S. politicians continually disagree on issues that could have severe consequences, both in the U.S. and globally?

We believe the answer comes down to the polarization of the U.S. Congress. Studies have shown that Congress is more divided now than at any time in recent history. This brings about an unwillingness to compromise. However, the legislative branch of the U.S. government and its interaction with the executive branch were created in ways that require compromise. As long as members of the federal government are unwilling to compromise and then legislate, we think U.S. politics are likely to remain a sporadic headwind for the markets and the overall economy.

The latest inability to come to an agreement over the budget in the form of a continuing resolution caused a U.S. government shutdown for the first time since the mid-1990s. It seems increasingly likely that resolution to the shutdown will be tied to a needed increase in the debt ceiling. Furthermore, it appears to us that members of the Republican leadership in Congress realize the ramifications of a technical default if the debt ceiling is not increased. We think there is a chance of a short-term solution — “kicking the can” down the road, so to speak — but that would mean policy makers still will need to deal with the same issues again in the next few months. While this means that markets could remain nervous in the short term, we think an increase in the debt ceiling is likely to get the U.S. past mid-term elections in November 2014.

In addition, it appears Congress may negotiate on additional deficit-reduction items during the next few months. In our view, this could include reforms in entitlement programs and tax laws, approval of the long-debated Keystone pipeline and some easing of the “sequester” that results in discretionary spending cuts each year. Whatever the outcome on the budget and debt ceiling, it is possible that there will be a similar battle at the endof next year or in early 2015.

Federal Reserve surprise

Policy from the U.S. Federal Reserve (Fed) also has been a key market factor in recent months. Many economists expected the Fed at the Sept. 17-18 meeting of the Federal Open Market Committee to reduce the pace of purchases of U.S. Treasury bonds and mortgage-backed securities, otherwise known as tapering. Those expectations were based on comments in the spring from Fed officials, which briefly caused bond yields to rise and stocks to fall. The Fed, however, surprised markets in September by announcing it would not make a change.

In its subsequent statement and the press conference with Fed Chairman Ben Bernanke, the Fed stated it needed more data to be sure that the labor market was improving sufficiently following the previous move higher in Treasury yields. Equity markets rallied, bond yields fell and the U.S. dollar weakened. Why were markets so surprised?

In May, Bernanke said he could foresee tapering sometime later in the year. As more Fed officials commented on the topic, it seemed that a consensus was building inside the Fed for action as early as the September meeting. While it has not been uncommon for central banks to surprise markets, the Fed under Bernanke has focused on transparency and communication with market participants and the public at large. This approach does not guarantee the Fed will signal every move, but it has led markets to believe that when the Fed says it will do something, it will follow through.

One of the Fed’s tools in recent years has been “forward guidance,” or giving the market direction on when to expect an increase in short-term interest rates. If the market cannot believe the Fed when it seems that officials are signaling a policy move such as tapering, can the market believe the Fed when it says that rates will stay unchanged until sometime in 2015? Given the reaction of stock and bond markets to its latest comments, we believe the Fed needs to be careful to guard its credibility from being damaged.

Promising economic outlook

What do these issues mean for the U.S. economy? We think the effects on economic growth from the battle over the continuing resolution are likely to be quite small. For example, the House of Representatives already has passed a bill providing back pay for government workers after the government reopens. The Department of Defense also has announced it will allow all defense workers to return to their jobs. In our view, most economists think that the hit to economic growth would equate to roughly 0.1 percentage point for every week the government is closed.

We think failure to raise the debt ceiling would be disastrous, with the potential for markets to plummet and economic growth to weaken dramatically or even fall back into recession. But we do not expect this outcome. We still believe U.S. economic growth is set to improve, although the recent deadlock in Washington brings some concern.

Internationally, growth continues to improve, mostly in line with our prior outlook. We think the economy in Europe is set to post slightly positive growth for both the third and fourth quarters of 2013. Growth in Japan has slowed a bit, although the government has confirmed a hike in the value added tax next year. We think this means growth is likely to increase through the first quarter of 2014 before falling off in the second quarter. In China, growth has been a bit stronger than we expected, with the domestic economy picking up in the last few months.

Emerging markets outside of China have been mixed. Those countries with large current account deficits have seen some pressure on their economies and currency exchange rates during the last several months. Local policymakers responded with higher rates and tighter liquidity, which we think should result in slower growth for the foreseeable future. Many emerging market countries have had significant inflows into local fixed-income markets, as well as stronger credit growth. We think these flows could be reversing, which would put further pressure on growth for some countries. Conversely, we think the outlook is brighter for those countries that have comfortable current account surpluses or that have not had strong credit growth. Many in this group are exposed to stronger growth in developed markets.

Overall, we think the global economic outlook should improve further as we head into 2014, driven by a recovery in developed markets that seems to be under way. However, we believe the lack of global political leadership and the inability for policy makers to reach decisions are, as always, a risk going forward.

Past performance is no guarantee of future results.The opinions expressed in this article are those of Mr. Hamilton and are not meant to predict or project the future performance of any investment product. The opinions are current through Oct. 16, 2013. Mr. Hamilton’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

Investment return and principal value will fluctuate, and it’s possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.

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