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Craig Allen: Renewed Fears over Debt Ceiling Trump Fed Tapering Concerns

Over the last several months, discussions about stock market performance have centered on the debate over when and by how much the Federal Reserve will taper off its bond-buying program — quantitative easing round 3, or QE3. With our attention focused on the possible impact of tapering, we have lost interest in the looming threat of running up against the debt ceiling once again, a threat that is all too real, and all too serious, in terms of the potential for serious downside for stocks.

Back in June 2011, as we neared the debt ceiling, contentious debate began between the Obama administration and Democrats, and congressioanl Republicans led by House Speaker John Boehner, R-Ohio. An agreement was finally reached that included spending cuts to offset the increase in the debt ceiling to $16.4 trillion. President Barack Obama signed the bill into law on Aug. 2, 2011. The following day, the U.S. Treasury increased our national debt by $238 billion, the largest single-day increase in history.

On Aug. 5, just three days after the debt ceiling was increased, Standard & Poor’s downgraded the U.S. credit rating to AA+ from AAA. At the same time, Europe was also experiencing massive debt challenges. The combination of the fight among politicians, the downgrade and international financial challenges culminated in the S&P 500 dropping to a low of 1,075 on Oct. 4, 2011, from a high of 1,347 on July 21, 2011 — or by more than 20 percent.

In May of this year, the debt ceiling was raised, yet again, to $16.7 trillion. Now, just four months later, we are up against the debt ceiling again. The debate between Democrats and Republicans appears to be heating up, possibly to an even more contentious level than we have seen previously.

The U.S. government’s fiscal year ends on Sept. 30 each year. Although there are possible stop-gap measures that can be used to keep the wheels of government turning for a few more weeks, if the debt ceiling is not raised, the government will essentially run out of money, and will no longer be able to pay its bills. This will mean widespread furloughs for thousands of government employees.

The Congressional Budget Office estimates that GDP will be negatively affected by 1.4 percent in the fourth quarter, if an agreement is not reached on the debt ceiling and the government is forced to shut down. If an agreement is delayed for an extended period of time, this negative impact could be even more severe.

Revised GDP growth in the second quarter of this year showed annualized growth of 2.5 percent. If growth is reduced by 1.4 percent, we would have growth of just 1.1 percent in the fourth quarter, assuming we stay on pace with the rate of growth experienced during Q2. We may get a bump in growth due to holiday spending that could somewhat offset the negative impact of a shutdown, but it remains to be seen if consumers will step up and spend this holiday season, especially if they are uncertain about the economy as a result of a government shutdown.

From a stock market performance perspective, a shutdown could serve as the catalyst to spark the long-awaited correction many of us have been expecting. The delay in Fed tapering after the most recent meeting of the Federal Open Market Committee was a shock, and stocks responded with fresh all-time highs. Since then, however, stocks have given back more than they gained after the Fed meeting, having lost 34 points (S&P 500) from the all-time high of 1,725, or about 2 percent.

Still, stocks have held up surprisingly well given that we are in September, which has been, historically speaking, the worst month for stock market performance going back at least 50 years. We ended August at 1,633 and are up, as of Friday’s close, 58 points, or by 3.5 percent. However, October has been a month during which we have seen several major crashes — 1929, 1987, 2008. Will the debate over the debt ceiling be the catalyst that causes a major correction or even a crash for stocks?

The Fed has two meeting remaining in 2013 — Oct. 29-30 and Dec. 17-18. If it is going to begin tapering by the end of 2013, an announcement will likely come at one of these two meetings. Last week, the first voting member of the FOMC, Charles Evans of the Chicago Fed, stated in a speech that the Fed may need to wait until 2014 before it begins to taper. This is the first time anyone on the FOMC has mentioned this possibility. All others, including Fed Chairman Ben Bernanke, have consistently stated that tapering will begin in 2013.

Tapering is a double-edged sword, for the Fed and for us — if the Fed decides to taper this year, especially in combination with the debt-ceiling shutdown threat, markets could crash. If it doesn’t taper in 2013, it will be because economic data shows that the U.S. economy is stalling, which could also cause a crash in financial markets.

The longer the Fed waits to taper, the greater the chance that other potentially damaging things will occur, such as a debt-ceiling shutdown, and the more likely we are to have a significant, negative reaction in the financial markets. If we survive through October without a major correction or crash, I will feel a lot more positive about the future prospects for the stock market. But as we enter October so close to all-time highs for stocks, my concerns about the possibility of a major correction happening in the short term have never been more intense.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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