A Lackluster Market Ahead As Budget Fight Is Looming

Includes: PZA, TIP, VEU, VTI, VXF
by: O. Young Kwon

A House GOP plan passed the House on Wednesday (January 23, 2013) by a vote of 285-144 with strong GOP support, and the Senate is likely to clear the House Debt Limit Extension bill, and the president would accept it. The House bill would suspend the debt limit into May 19. The bill includes a provision that the House and Senate must pass a budget - or the members of Congress would see their salaries withheld, but it does not include any specific spending cuts. The Senate under the majority leader Harry Reid has not passed a budget since 2009. The House bill contains this requirement to make sure that the nation will have budgets in April. Last four years, the government has been able to spend by actual spending bills instead of formal budgets.

The GOP move represents the clear signal that Republicans will not use the debt ceiling as a battlefield for their next budget fight with the president. The GOP lost a battle on the previous cliff deals, giving the president what he wants without getting any spending cuts. Last time the speaker was in somewhat a weaker position due to the election outcomes. As a result, he took an initiative, by compromising on the tax issue, and by proposing his Plan B later. This time, the president took an initiative to urge Congress to act on an increase in the debt ceiling. The current position of the president is weaker than the previous one? The speaker answered:

The real showdown will be on the debt ceiling and the spending sequester in March…Republicans won't back down from…Boehner rule: that every dollar of raising the debt ceiling will require one dollar of spending cuts over the next 10 years. Rather than forcing a deal, the insistence may result in a series of spending sequester trigger that trims all discretionary programs - defense and domestic. It now apparent that the president made a severe miscalculation when he came up with the sequester idea in 2011…[The speaker]…has significant Republican support, including GOP defense hawks, on his side for letting the sequester do its work…[T]he president's liberal base putting pressure on him when cherished domestic programs face the sequester's sharp knife." (From "The Education of John Boehner" interviewed by Stephen Moore, The Wall Street Journal, January 7, 2013, p.A13)

The debt-limit issue is equally important as the deficit problem. The consequence of a failure of the former is much higher than the latter in the short term as well as the long haul. The final comprehensive solution will be obtained after a long and painful process. The president's move on January 14, 2013, however, called investors' attention. The Wall Street Journal's editorial ("The Next Tax Increase," January 15, 2013) proclaimed:

President…[makes] essentially two points: He won't negotiate with Republicans over raising the federal debt limit, and if Republicans want any spending cuts at any time in the next four years they have to raise taxes along with it…Mr. Obama and the Democrats are all but conceding that the recent tax hike is little more than a token reduction in the deficit. The tax hike, while the biggest in 20 years, will raise only $620 billion at most over 10 years, and probably less…Republican leaders Mitch McConnell and John Boehner have ruled out any such tax increase, at least outside of a tax reform that also cuts tax rates…Mr. Obama has turned that strategy into spend, borrow, elect and tax. And then tax some more. Republicans had better start educating the public about this, or they'll end up having to raise taxes again.

The president didn't show any room to compromise on the Cliff negotiations. This time he becomes tougher by demanding more tax hikes. The important battles on the deficits and debt resolution, focusing on spending cuts, will approach on March 1, or on March 27, or on April 15, depending on how the president and Democrats will respond to the House bill. Spending sequestration or shutdown of government operations will force both parties to be on a negotiation table. If the Senate fails to pass the House bill, then on March 1, the sequester, deferred by the completion of a tax deal, is scheduled to be kicked in.

On March 27, all stopgap spending measures are expired. As a result, new appropriation bills are needed for the Treasury Department to continue to spend. Republicans will have a chance of spending-cut deals this time. The other case is that even if Congress successfully moves forward over these two hurdles, there is still a final battleground on April 15 when formal budgets must pass Congress. Therefore, Republicans have an ample opportunity to negotiate with the president and Democrats on spending cuts to reduce the government debt in the long term. The Republicans now craft a budget plan that would erase the annual deficit within 10 years by cutting government spending - and without increasing revenue.

The House and the Senate would be required to pass separate budget resolutions by April 15. What if Congress cannot pass budgets? The House would pass a new bill to extend the deficit limit for another three months. Keith Hennessey proposed three steps in "How to Wage the Debt-Ceiling Fight" (The Wall Street Journal, January 17, 2013, A17). Step three would be a right step for GOP to take on this situation:

Step three is the crucial lever for applying public pressure to Democrats to cut spending. Congressional Republicans would explain that they will support the first alternative - a long-term debt-limit increase coupled with spending cuts…[I]f Mr. Obama agrees to cut spending, he will get his long-term deficit-limit increase and most Republicans would vote for it. If, however, he refuses to cut spending and instead choose repeated short-term increases, then he and House Minority Leader Nancy Pelosi would have to ensure that all 197 House Democrats vote aye. House Speaker John Boehner would commit to delivering only the 20 or so Republican votes that are needed to ensure the bill passed. Similarly in the Senate, Republicans would commit to support in larger numbers a debt-ceiling increase that also cut spending…If the President and his party refuse to cut spending, then Senate Republicans would oppose but not filibuster repeated clean three-month debt-limit extensions, which would pass the Senate, relying entirely on Democratic votes…It's hard to overstate how much members of Congress in both parties hate to vote for a debt-limit increase, and how entitled to ducking the vote House Democrats to take responsibility for more borrowing without spending cuts, over and over again…If Mr. Obama not only refuses to lead, but prevents others from doing so, then congressional Democrats should bear the political weight of voting to raise the debt limit every three months until voters make their choice in the next election.

The outcome of the political event is extremely uncertain for four months. The market is expected to be trendless and more volatile for this period. It is important for investors to set a reliable investment strategy: A two-tier portfolio, containing a long-term investment portfolio and a short-term trading portfolio, would be desirable to reflect the long-run market perspectives (i.e., inflation expectations) and the short-run market opportunity. It is better to adjust the allocation of assets gradually, not on an on-off basis. This way can minimize the downside risk without giving up the upside potential too much.

ETFs are more favorable than individual securities as investment vehicles this time. Index ETFs are appropriate to build long-term portfolios because they are broad, low-cost, and tax-efficient. My five favorites are iShares Barclays TIPS Bond ETF (NYSEARCA:TIP), Power Shares Insured Muni Bond ETF (NYSEARCA:PZA), Vanguard Total Stock Market ETF (NYSEARCA:VTI), Vanguard Extended Market ETF (NYSEARCA:VXF), and Vanguard FTSE All World ex-US ETF (NYSEARCA:VEU). TIP, PZA, VTI, and VTF are the members of The TANER ETF Model. VEU is a component of The TANER Vanguard Model. Both Models are included in The TANER System, which was introduced in The RED Spread: A Market-Breadth Barometer - Can It Predict Black Swan?"

Investors know that the market doesn't expect a miracle on looming debt-ceiling fight. The market is ready to face even a government shutdown as the one in 1995-96. Fortunately, the current market condition is pretty solid because (A) the increasing supply of U.S. oil and natural gas gives a positive effect to the economy, (B) the industrial, financial, and housing sectors are rebounding, (C) the Fed continues to purchase Treasuries and mortgage-backed securities, and (D) the global economy is improving, led by China, Japan, and the Euro zone. As a result, any negative impact of the debt negotiations will probably be offset.

It's possible that with a merest good result of debt resolutions, the market may move up sharply. Even without such a good luck of the sort, the market may shrug it off and make a lackluster advance. This is because the character of political events is that the event becomes binary eventually when we ultimately have a comprehensive resolution, but the event is progressive until then because many parties are involved. The final consensus solutions require many steps and time.

A key successful strategy for investors is a rule of "disciplined flexibility," explained in my previous article. For Republicans, "what Mr. Ryan termed 'principled prudence'" is their current winning approach "to avoid fighting an unending series of short-term skirmishes with Democrats, as they did last year." ("Adding Some Prudence to Republican Principle" By David Wessel - The Wall Street Journal, January 24, 2013, A4) Do we have any chance to see a Black Swan? No, not this time, but it's going to be choppy.

Disclosure: I am long BND, EDV, ELD, PHB, PZA, VCR, VDE, VIS, VMBS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.