David Joy Weekly Market Commentary, July 25

The failure to reach an agreement to raise the debt ceiling in the U.S. has increased the level of stress in capital markets around the globe. A deal is still likely to get done, but until it does, the risk of the worst case outcome, a selective default, remains a possibility as the deadline approaches. In China—holders of $1.6 trillion of U.S. debt—the Shanghai Composite index was down 3.0 percent on Monday, while stocks in Europe were lower in the fiscally challenged periphery markets but relatively flat in the stronger core economies. Stocks are lower in early trading in the U.S. as well, led by financials which have the most direct exposure to a possible downgrade or default of U.S. debt. Bond prices are lower as well. The yield on the 10-year Treasury note is higher in early Monday trading by six basis points at 3.02 percent, while European sovereign debt is behaving in similar fashion to equity markets with weakness concentrated in the lower quality markets. The dollar is modestly weaker as well, and gold is higher. Interestingly, we have not seen yields on lower quality paper rise in the last week as the impasse in Washington intensified. The yield on the Bank of America Merrill Lynch High Yield Master II Index actually fell seven basis points last week to 7.45 percent, and its spread over treasuries narrowed 17 basis points to 540. In contrast, the yield on the higher quality AA corporate bond composite rose three basis points to 2.95 percent.

Despite the absence of a deal on the debt ceiling, getting one remains the most likely outcome. The possibility of a broad agreement that substantially closes the budget gap over the next ten years seems increasingly unlikely, however. That leaves a short-term fix—which raises the debt ceiling for a period of a few months only, without any real progress on the deficit—as the most likely outcome. Although that would certainly be better than no fix at all, resulting in a selective default, it would leave us with the prospect of going through this idiocy all over again, perhaps in January. It would also expose the U.S. to a realistic possibility of a debt rating downgrade. The disruptive potential of such an outcome will hang over markets until a long-term deal on the deficit is reached, or until a downgrade occurs. This period in limbo would be analogous to the debt crisis in Europe, where the inability to reach a consensus resulted in a series of short-term fixes, and little confidence among investors that the problem has been resolved. In response, it becomes increasingly difficult for businesses and investors alike to make investment decisions with confidence, creating an unnecessary headwind for the economic recovery.

If it is possible to focus on fundamentals in the face of the debt ceiling uncertainty, there is no denying that second quarter earnings season has been quite strong. About 30 percent of the companies in the S&P 500, representing about 44 percent of its market cap, have reported with three-quarters of them beating expectations. In addition to positive earnings surprises, companies are also beating expectations in terms of revenue growth and profit margins. This performance suggests that corporations have adapted well to the slow growth environment in the developed world and are taking advantage of the faster growth in the developing world. Unfortunately, this has yet to translate into faster job creation, which ironically partly explains the stronger earnings. Management guidance has been relatively positive as well. Some companies, particularly in the industrial sector, report that activity seemed to firm late in the quarter with expectations that this momentum would carry into the third quarter. For that to be the case we will need to see evidence that the global economy is throwing off the headwinds of the second quarter and resuming a stronger growth trajectory. So far, there is only scant evidence that will emerge, but it is early in the quarter. Meaningful data will only start to trickle in slowly. And in the meantime, we will get the first estimate of second quarter GDP on Friday, and with a consensus forecast of just under 2.0 percent will serve as a reminder of just how soft activity was in the period. Earnings reports continue this week, including Dow components 3M, Boeing, DuPont, Exxon Mobil, Chevron, and Merck.

For investors in the immediate days ahead, a somewhat higher than usual liquidity cushion is in order. Until we actually see some kind of deal to raise the debt ceiling, this seems like the prudent course. On the other hand, neither does it appear necessary to sell out of solid long-term positions. The combination of robust corporate earnings growth and a stock market that has been range bound for the past several months has left equity valuations attractive at 13.5 times this year’s expected earnings. And our long standing preference for corporate bonds versus treasuries remains in place, especially given their better credit quality and relative insulation from the politics of the debt ceiling debate.

Important Disclosures
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The Shanghai Composite Index is a capitalization-weighted index of all stocks on China’s Shanghai Stock Exchange.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

The Bank of America Merrill Lynch Corporate Bond Index is an unmanaged index that tracks the performance of AAA, AA, and A U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

It is not possible to invest directly in an index.

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