Market Insider

Week Ahead: Debt-Talk Drama Puts Market on the Defensive

A fractious impasse in Washington's debt talks puts markets on the defensive and will likely lead to heightened volatility in the week ahead.

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The bipartisan squabbling came to a head late Friday when House Speaker John Boehner broke off talkswith President Barack Obama. Congressional leaders were expected to continue talks as they have just a few days to reach a compromise and put aside ideological differences over spending cuts and taxes. The debt ceiling must be raised by Aug. 2 to avoid default, and ratings agencies have said they also want to see a serious plan for deficit reduction or the triple A credit rating of the United States will be in jeopardy.

For the most part, markets expect the debt ceiling to be raised, but there was increasing speculation towards the end of the week about a potential downgrade of the U.S. credit rating since Congress is still far apart on deficit reduction. Standard and Poor's said there was a 50-percent chance it would cut the triple-A rating, and a number of strategists said the odds are rising the longer the standoff continues.

"The debt-ceiling debate is very fluid, and it's difficult to gauge exactly when and which agreement will be reached. I think that it's certainly something that is going to weigh heavily on markets next week, whichever way it's going to be resolved. They don't have a lot of time, and they still don't have an agreement," said Barclays chief U.S. economist Dean Maki.

"One thing we have found in our research is the longer uncertainty stretches out, as measured by indexes, like the stock market volatility index (the VIX), the weaker job growth becomes," Maki said.

The high-stakes drama comes during a week when economic data is expected to show the second quarter was another quarter of anemic growth. Friday brings the first look at second-quarter GDP and economists expect it to show sub-2 percent growth, a pace too sluggish for any meaningful job creation.

There are also earnings reports expected from about a third of the S&P 500, including Boeing, Ford, Texas Instruments and big oil names ExxonMobil and Chevron.

"I think if we weren't looking at these other issues, and we didn't have the high unemployment rate, then I think the market would be responding a little bit more to the earnings numbers," said Stuart Freeman, chief equities strategist at Wells Fargo Advisors.

Freeman said he expects the debt ceiling to be raised and the market could see strong gains the day a plan is announced. But individual investors remain scared, and the debt feud in Washington keeps them sidelined.

"We still have a lot of volatility and investors are nervous about that. They're nervous about the coverage they hear on our debt ceiling, and they hear a Social Security payment might be missed. That doesn't comfort anyone ... Those things all add to stress in the markets. 2008 wasn't that long ago. That kind of market is fresh in their minds and everyone doesn't understand the difference between the economy we're in today versus the economy we were in then," he said.

Stocks finished the past week with solid gains, after European leaders struck a deal to include the private sector in the bailout of Greece, clearing the way for a new aid package. The Dow was up 201 points, or 1.6 percent to 12,681, while the S&P 500rose 2.2 percent to 1345. The Nasdaq was the standout, rising with tech, to 2858, a gain of 2.5 percent. The Standard and Poor's technology sector was up 3.7 percent.

Freeman expects to see about 70 percent of the S&P companies beat earnings estimates by the end of the reporting period.

"We're still comfortable with our target — 1250 to 1300 range (on the S&P 500). If this slow period we've had picks up a little bit during the summer, I think confidence picks up and we could go above that 1300 level, and maybe we'll see 1350" at year end, he said. Freeman said one wild card is oil, which has resumed its rise. Gasoline prices are also moving higher again, and he is concerned they could become a bigger headwind for consumers if they keep rising.

West Texas Intermediate crude was up 2.7 percent in the past week to $99.87 per barrel, and Brent crude was at $118.51, a gain of 1 percent. Gold was up nearly a percent, finishing the week at $1601.50 per ounce, its first week above $1600.

Debt Dilemma

Greg Valliere, chief political strategist at Potomac Research, said he expects to see some sort of compromise deal by mid week to raise the debt ceiling and trim $1.5 trillion from spending. That is well below the $3.7 trillion discussed by the bipartisan "gang of six" senators.

In the bond markets, traders believe several trillion will be needed to pacify ratings agencies. "I think it's enough for the rating agencies," Valliere said of his $1.5 trillion estimate. "These rating agencies were sound asleep at the switch in '08. They missed it all and now they get to play God and rule whether the debt deal is sufficient?"

"There's so many moving parts, if there's no deal by mid-week or they're close and they still don't have a deal, I don't rule out a short-term extension. There's not going to be a default. Every key player with the possible exception of (Rep. Eric) Cantor (R-Va.) thinks a default is unthinkable," Valliere said.

Barclays Capital credit strategists said the Aug. 2 deadline may also be more flexible than has been suggested since it is based on cash flow. In a note, they wrote it now appears that tax receipt inflows since July 14 have been stronger than they expected. "This suggests that the date on which the Treasury will run out of cash to pay its obligations might not be August 2; it might be around August 10 instead," they wrote.

Zane Brown, fixed income strategist at Lord Abbett, said if the credit rating were cut, it could result in a rise in student loan, business loan and mortgage rates.

"Our perception would be that they appear to understand the consequences of a potential downgrade. They've appealed to S and P not to downgrade for fear of financial market mayhem. I think if you ended up with a downgrade, you would have forced sales by entities that have to have a Triple A. That could cause economic consequences for the markets and push up yields unnecessarily," he said.

Citigroup credit strategists, in a note, said they see a 50-percent chance of a rating downgrade to AA. "We see little forced selling from the main holders — central banks, commercial banks and money mangers — of Treasury, agency MBS and agency debt. Accordingly, we see little market impact," they wrote. However, a ratings downgrade could significantly widen spreads in the government guaranteed student loan market since investors require a AAA rating. They also noted that long term municipal debt would be more affected by the spending cuts than by a credit downgrade Short-term municipal instruments could be affected if the banks providing liquidity backstops are downgraded as well, they wrote.


It's a busy week for economic news, with Friday's first look at second-quarter GDP the highlight. Economists expect growth of 1.8 percent, slightly lower than the first quarter's 1.9 percent. Another big one to watch is weekly jobless claims on Thursday. The Federal Reserve will release its "beige book" report on the economy on Wednesday. The government will also auction $99 billion in 2-year, 5-year and 7-year notes, Tuesday through Thursday.

Housing data is also big with S&P/Case Shiller home prices and new home sales on Tuesday, and pending home sales on Thursday. Durable goods is due out on Wednesday, and Chicago PMI is on Friday. Consumer confidence is reported Tuesday and consumer sentiment is reported Friday.

Earnings Central

Energy companies, tech, consumer products and auto companies are among the companies reporting in the coming week, as about one third of the S&P 500 report.

Monday's reports include Netflix, Texas Instruments, Kimberly-Clark, Eaton, Anadarko Petroleum, Lorillard, Ryanair, Six Flags, and Broadcom. Before the opening Tuesday, BP, Ford, Deutsche Bank, MMM, UPS, CIT, Cummins, Hershey, Illinois Tool Works, JetBlue, Valero, Lockheed Martin, and Occidental Petroleum report., Electronic Arts, Gilead Sciences, Norfolk Southern, DreamWorks, and Nabors report after Tuesday's closing bell.

Boeing, Conoco Phillips, Aetna, Northrop Grumman, Aflac, Whole Foods, AutoNation, Corning, Delta, Dr. Pepper Snapple, Dow Chemical, General Dynamics, Hess, Murphy Oil, Nasdaq OMX, WellPoint, and Southern Co report Wednesday. Thursday's reports include Exxon Mobil, DuPont, Royal Dutch Shell, Barrick Gold, Boston Scientific, Bristol-Myers Squibb, Kellogg, Time Warner able, Thomson Reuters, Sprint Nextel, MF Global, Goodyear Tire, Siemens, AstraZeneca, Credit Suisse, Starwood, Potash, and McGraw-Hill all report Thursday morning. Chesapeake Energy, Expedia, Starbucks, and MetLife report after the close.

Chevron, Merck, Newmont Mining, Aon, Amgen, Weyerhaeuser, and American Electric Power report Friday.

Reporting Next Week

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