D.C. and the Long-Term Investor
Washington's policy debates and debacles could create real short- and long-term risks for equities, but stock investors shouldn't wave the white flag, says Morningstar's Jeremy Glaser.
Jason Stipp: I'm Jason Stipp for Morningstar.
Congress reached a deal late Wednesday to reopen the government and avert the debt ceiling crisis, but only for a few months. So what does this mean for investors?
Joining us with his insights is Morningstar markets editor Jeremy Glaser.
Jeremy, thanks for being here.
Jeremy Glaser: You're welcome, Jason.
Stipp: Let's talk first about the contours of this deal. There wasn't really a lot to it, even though it was a big deal that got done yesterday.
Glaser: There really wasn't. They passed a continuing resolution to fund the government through Jan. 15. The debt ceiling got raised into early February. ... They also set up a budget conference to try to reconcile the budgets that the House and the Senate passed. But there really wasn't a whole lot of other policy in there, and it really just kicks the can down the road into January.
Stipp: We know that the government was shut down going into its third week, so it's going to reopen, but probably some real economic damage was done from that. The debt ceiling, however, we didn't run up against it. We didn't have that crisis of unknowns that could have happened. So can we say with the debt ceiling, at least, no harm no foul, because they were able to get this bill passed?
Glaser: I think there was some damage that happened from both the shutdown and the debt ceiling. It's probably hard to disentangle one from the other in terms of confidence and loss of investment through that period, as businesses maybe were on the sidelines, waiting to see what would happen. But as Bob Johnson has pointed out, some of the spending [lost during] the government [shutdown] just isn't going to come back. We're going to see lower growth.
We're already seeing third-quarter earnings coming in, if not very weak, [at least] not showing great growth. Fourth-quarter earnings estimates probably look a little bit too high right now. I think we're going to see a lot of management teams bring guidance back in. We are already seeing that a little bit.
So I think there was a real economic impact. We certainly avoided the worst of it, or even that middle-worst scenario, but we didn't escape from this completely unscathed.
Stipp: We also saw part of this deal is going to involve a budget conference, where both sides are meant to come together so that they can reach a longer-term bargain about some of the issues that we have in the government with our spending and with our debt. Do you expect that we'll see anything meaningful come out of that?
Glaser: I wouldn't expect much from this conference. Jan. 15 is also the date that the next round of sequestration cuts come into effect, and I think most of the discussion in this conference is going to be what to do with those cuts. Remember, these weren't really designed to be implemented. They are across-the-board cuts that were meant to be painful to both parties, so that they would come together in that super committee, if you can remember that, that was going to come up with this longer-term deal.
I think we're going to see a lot of horse-trading with what happens to those sequestration cuts. I would guess that the general level probably won't be reduced significantly, but that the areas that are going to get cut might see some changes. There might be some more flexibility in how those cuts play out. I think those are the kind of deals that the two sides are going to have the potential to reach in this short period of time.
Anyone hoping for a grand bargain is going to be disappointed. There's still just too much of a divide between the Republicans and the Democrats on issues like the right way to raise revenues. Does it make sense to raise taxes? The Democrats think yes. The Republicans think no. How do you cut Medicare spending? How do you reform Social Security? Even where people know the levers that need to be pulled in order to fix some of these entitlements, it's difficult to actually pull them, difficult to make those decisions, particularly in such a short period of time.
There's some talk about tax reform; both parties have said, ideally, they'd like to broaden the base of taxes, but lower those rates to be a little bit more economically efficient. But even that's really challenging. We're constrained by the decisions we've made in the past--kind of this path-dependency problem. Look at the mortgage interest deduction, for example. Even if parties wanted to get rid of it or they decided to scale it back, you have so many Americans who have taken out mortgages, with the expectation that they'd have this mortgage-interest deduction. You have the homebuilders, you have a lot of lobbying groups that really need to keep that deduction in place to keep their businesses going, to keep the housing market running smoothly. So the chances of that going away become relatively small. And you look at that across all the different kind of tax credits that we have, different types of deductions we have, and each has a lobbying group, it's very difficult to really overcome that, particularly in a short period of time. So we wouldn't expect any major deal on taxes, either.
We could get something out of it. It's not totally a lost cause in terms of some changes to the way that we're spending right now, but it's probably not going to be a major change.
Stipp: A lot of the things you're talking about that would be in this longer-term bargain--entitlement spending like Social Security and Medicare, maybe refining the tax code so that it's more efficient--those are meant to address some longer-term problems that everyone pretty much agrees that we have, though how we solve them is up for debate. But if they don't solve it in the short term, is that a huge problem for the government, for the country, and for investors?
Glaser: It's probably not the end of the world right now. We've already seen significant fiscal consolidation over the last few years thanks to an improving economy, the sequestration cuts, and the higher tax rates. What we've seen is that the deficit has gone from 10% of GDP in 2009 down to 4% this year. It's going to go down to 2%, according to the Congressional Budget Office, under current law, and it stays there to 2018, before beginning to tick back up again and then eventually moves pretty strongly higher as those medical costs really start to grow as the population ages.
I think that having that deficit continue to shrink now, and entitlement reforms being a problem a few years out, does give Washington a little bit of breathing room, so they don't have to make the deal right now. But they do have to make it eventually. Like you mentioned, almost everyone sees this as really a major long-term problem, one of the big things that need to be solved, and I think that, unfortunately, the political climate right now is not one in which this is likely to get done. Maybe in a few years, both sides will be more able to make these kind of deals, will be able to get some of the longer-term reforms that we need. But if it doesn't happen right now, or it doesn't happen in 2014, it likely won't be a catastrophe.
Stipp: We've been through this three-week crisis now where the markets were volatile. They didn't sell off as badly as we had seen in some past, similar crises. But now you say at the end of it, we're still having a lot of the same disagreements. People still are entrenched in their ideologies. So, what, as a long-term investor, should I think about all of this? Certainly, I want to look past the short-term ups and downs, but over the long term, what should I think about my portfolio given that we do have these big problems still facing us and at least in the short term, there is probably not likely going to be a big solution?
Glaser: This really is a hard problem. We're fundamental investors. When we think about stock investing at Morningstar, we're thinking about the value of individual companies and not trying to making macro calls that we could very well get wrong, that are hard to do, and it's difficult to execute those trades. But that being said, what happens in Washington is going to have a real impact on earnings and could have a real impact and could produce permanent impairment of different securities.
In the short term, you look at things like a default, which would have a really negative impact on a lot of different industries, a lot of different stocks, and you could see earnings really be permanently impaired there.
Over the long term, if we don't solve these entitlement issues, if we don't figure out how to get the debt under control, that's going to have a major impact on growth, and it really is going to make it difficult for those companies to grow their earnings and for investors to participate in that.
But these risks exist, and there are a lot of other risks in investing. I think that stock investors are getting compensated for that risk. You're taking on more risk when you're buying equities, certainly, but you should be getting return for that as well. And we still think over the long term, stocks are the best value-creating vehicle for investors.
But it's important to have stocks in the context of an asset allocation that makes sense. So, in the short term, that means having things in cash or liquid investments that you're going to spend on your living expenses that you need right now or to pay for college tuition or another immediate expense. And have your stocks in a bucket that are going to be for the long term, that you're not going to need to tap for a long time. So, if there is a crisis, and we do see the stock market sell off again, which is certainly possible, you'll have time for that to recover and time for earnings to recover before you have to tap into that money.
If you have that reasonable allocation, it's OK to tune a little bit out of Washington and hope that some of these long-term issues do eventually get fixed. And I'm optimistic, given that people accept that these really are problems and that we understand we need to come up with solutions, that we will eventually be able to do it, even if it's not all in one fell swoop, even if it's not in some grand bargain, that we will eventually make the reforms that we need in order to keep everything growing.
Stipp: Washington may make it difficult to be an investor from time to time in the short term, but thanks for helping us keep our eye on the long-term, Jeremy.
Glaser: You're welcome, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.