Monday Look Ahead: Debt Deal Rally Could Be Short-Lived

With President Obama announcing a deal had been reached to raise the debt ceiling and cut spending by $2.4 trillion over 10 years, stocks in Asia were rallying on Monday morning with both the KOSPI and the Nikkei 225 up around 1.7 percent. U.S. stock futuresare also up sharply, with the Dow futures up 176 points.

But that relief rally could just be short-lived as investors turn to the weak economy and a possible U.S. credit downgrade.


The deal needs to be done by Tuesday, and already it was seen as not sufficient to ward off a one notch downgrade of the AAA U.S. sovereign credit rating by Standard and Poor's. Moody's, however, is not expected to follow suit, and is seen giving the U.S. more time to manage its deficit.

"My expectation is we get a little bit of a bounce and then the market isn't able to sustain it," said Barry Knapp, head of equities portfolio strategy at Barclays.

"I don't expect the reaction to be very long-lived. $2.8 trillion is not enough to stall the downgrade," he said. He added that Friday's disappointing GDP report, which showed more sluggish than expected first half growth, led Barclays economists to trim their second half forecast. They cut GDP growth to 2 percent in the third quarter from 3 percent and 2.5 percent from 3.5 percent for the fourth quarter.

"I don't think that another round of GDP reductions is priced in," Knapp said. Sluggish growth, below 3 percent, is not enough to create jobs in an economy with 9.2 percent unemployment.

The big economic report this week is Friday's July employment report, expected now to show that about 100,000 jobs were created in July. But the past two months showed flat growth in jobs after more promising reports earlier in the year.

"I think "deal" provides some relief rally but market does not turn up until macro data does," Deutsche Bank chief U.S. equities strategist Binky Chadha, wrote in an email Sunday. "I see the recent data as indicating the uncertainty created by debt issues in U.S. and euro areas have slowed activity, so it takes longer."

For the same reason, any dollar rally may be short-lived. "We are going to have a reflex dollar rally. It's going to be knee jerk. Going forward, the focus is going to start moving toward the economic data. And that's why I think the dollar rally could run out of steam," said Boris Schlossberg of GFT Forex. "This is just going to be an adjustment off of oversold levels."

Other data this week includes Monday's ISM manufacturing report, ADP's payroll report Wednesday and jobless claims Thursday. Economists are also watching car sales Tuesday, and monthly chain stores sales Thursday.

One factor behind the revisions in first half GDP was lower federal government spending in the first quarter. The first quarter is now reported to have grown just 0.4 percent and was also affected by lower private investment by businesses and individuals.

"I've been worried about Europe, that they're too fiscally aggressive on fiscal contractions. We ought not to go too quickly," said James Paulsen, chief investment strategist at Wells Capital Management. "A $3 trillion package is a fairly good move, and I'm not sure you want to move much faster than that but because you risk unintended consequences if you do more," he said.

Analysts have said while the market will respond to positive signs of fiscal discipline, there is a risk that cuts could go too deeply and quickly to an economy that is hardly growing.

Paulsen said the economic data will start to dominate the market week if the debt vote is done in time. "Last week, jobless claims were better. There's some disconnect (in the data). ..It's a big week coming up. I kind of hope the government gets out of the way," he said.

Wall Street has fretted about the potential S&P downgrade, and there are mixed views on what it would do. Many expect interest rates to rise, as a result. But Paulsen said if it is just one notch and Moody's does not join it, it may not make a huge impact.

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