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Debt ceiling battle could overshadow earnings

Traders work the floor on the NYSE the first day of the government shutdown.
Adam Jeffery | CNBC

U.S. stock investors, hoping to leave politics aside to focus on fundamentals, aren't getting their wish as lawmakers battle over raising the debt ceiling.

Proof that political uncertainty was holding down markets was seen Thursday and Friday as the S&P 500 generated two days of strong gains in advance of the weekend.

Legislators will be busy negotiating raising the $16.7 trillion federal borrowing limit and reopening the federal government. If the borrowing cap is not increased by Oct. 17, it could lead to a U.S. debt default.

The government has been partially shuttered since Oct. 1.

The shutdown has lasted longer than many expected, and while proposals from both President Barack Obama and congressional Republicans have been viewed as signs of progress, a final agreement remains elusive.

When not worrying about the government shutdown, investors will dive into the first busy week of third-quarter results, led by bellwethers General Electric, Goldman Sachs and Google.

"If we see a deal over the weekend, the market will trade back to where it was before all this concern settled in, near all-time highs,'' said David Joy, chief market strategist at Ameriprise Financial in Boston. "Otherwise we'll probably fall back to 1,650, possibly further, depending on how rancorous the disagreement is.'"

Increase in volatility

The S&P 500 is above its major moving averages, which could serve as support in the case of a market decline. The benchmark index is 0.9 percent above its 50-day moving average of 1,678.22, and 1.8 percent above its 100-day average of 1,662.53.

Many analysts have forecast increased volatility the longer the market goes without a deal. The CBOE Volatility index spiked this week above 20 for the first time since June. Trading in VIX futures suggested more concern about the near-term market trend, as well.

Data showed investors were willing to pay more for protection against a slide in the S&P 500 now opposed to three months down the road. On Wednesday, the spread between the VIX and 3-month VIX futures briefly hit its lowest since late 2011, at around negative 2.

That condition reversed Thursday when the market rallied sharply, but traders remain on guard against another jolt of volatility if Washington politicians emerge from the weekend without any progress.

The indexes' weekly performance was mixed. Late in Friday's session, the Dow Jones industrial average rose 0.5 percent, the S&P added 0.2 percent and the Nasdaq fell 1.1 percent, pressured by selling in some of its best performers this year, including Netflixand Tesla Motors.

While most analysts said a default on U.S. debt would be catastrophic for the economy, they also said it was highly unlikely that a deal would not be reached.

Ken Fisher, who oversees $49 billion at the Woodside, Calif.-based Fisher Investments, said there was a "maybe 0.0001 percent chance'' the debt ceiling would be breached.

House Republicans to hold meeting Saturday

"People have been saying that things are different this time, but Washington is just a distraction for markets, simple as that,'' he said. "If a default was possible, you would see bond prices fall through the floor. Eventually you have to stop listening to the people crying wolf.''

Notably, investors in the short-term Treasurys market are preparing in case of a missed or delayed payment. Yields on bonds maturing from late October through year-end are elevated as investors shun those issues because of the default threat.

Earnings heat up

Next week is a busy one for corporate earnings. Results and outlooks from banks may be the most important, as investors look for companies' comments on how the shutdown may affect growth and the impact of higher interest rates. Among the early indications, Wells Fargo said revenue from home refinancing fell to its lowest level since the second quarter of 2011.

"The shutdown will impact earnings growth some, but I expect the negative effect will likely be small,'' said Fisher. "We're clearly still in the middle phases of a bull market.''

S&P 500 companies are expected to post earnings growth of 4.2 percent in the quarter, down from the 8.5 percent forecast on July 1, according to Thomson Reuters data.

Of the 31 S&P components that have reported thus far, about 55 percent have topped expectations; the historical average is 63 percent.

While some government-prepared economic data will be delayed next week, including consumer prices and housing starts, those still scheduled include the New York Fed manufacturing survey and Philadelphia Fed survey, both for October.

Monday is Columbus Day and a federal holiday. Stock markets will be open, but the government will remain shut.

—By Reuters