Markets Regain Footing, Not Faith

by on July 30, 2012 2:36 am BST

This week marks an anniversary most investors would rather not celebrate. A year ago, markets entered the most tumultuous period since the depths of the financial crisis.

As U.S. policy makers wrangled over the nation’s debt ceiling, investors endured hair-raising plunges in stock markets. Within seven days, the U.S. had lost its triple-A credit rating from Standard & Poor’s.

There were dire predictions: Investors would flee U.S. Treasurys, sending the government’s interest costs higher. Stocks would plummet.

Bloomberg News

Traders on the floor of the New York Stock Exchange on Aug. 4, 2011.

Looking back now, those bleak forecasts seem overblown. The flight of money from the U.S. never materialized. Instead, investors flocked to Treasurys as a haven. Stock markets, after a harrowing few months, have recovered to new postcrisis highs. On Friday, the Dow Jones Industrial Average closed above 13000 for the first time since May 7.

But one hallmark of that time remains: a loss of faith in decision makers that has permeated the financial markets. From the U.S. to Europe, officials’ failure to tackle their debt burdens has rocked investors’ confidence, driving many to the safety of Treasury bonds. While the Federal Reserve has helped underpin the stock market by keeping interest rates near zero, many investors say they still have less than usual in the stock market. Individual investors have retreated, sucking money out of stock mutual funds.

The result has been, and is likely to remain, increased volatility in stocks, sluggish economic growth and continued rock-bottom interest rates, investors say.

Today, investors still face a litany of worries. They range from Europe’s unresolved debt crisis to the U.S. election to the impending “fiscal cliff” at the end of the year, when lawmakers will be forced to decide whether to cancel scheduled tax increases and spending cuts. All this is layered over a global economy that is slowing.

On the surface, it might not look like the debt-ceiling debacle and downgrade had any lasting impact. In the U.S. Treasurys market, where some forecasts predicted a jump in interest rates, yields are significantly lower. The U.S. Treasury 10-year note is yielding 1.55%, down from 2.6% hours before the downgrade hit.

Despite a brutal selloff that came in August and September 2011, the Dow Jones Industrial Average is up 7.7% from Friday, July 29, right before the debt-ceiling deal was reached. The Dow is also up 14% from close of trading on Friday, Aug. 5, just before S&P announced it had downgraded the U.S.’s long-term credit rating. The price of gold, meanwhile, is down slightly since then.

“On a stand-alone basis, the story is that the downgrade didn’t matter,” says Mohamed El-Erian, co-chief investment officer at money manager Pacific Investment Management Co. in Newport Beach, Calif., a unit of Allianz SE.

But the reluctance of leaders in the U.S. and Europe to find ways to address their debt burdens is weighing on the sentiment of investors as well as corporate leaders, says Mr. El-Erian.

Many investors expect politicians to do the bare minimum needed to avoid a disaster for the economy. In addition, some forecasters say the U.S. may again reach its debt ceiling in December, prompting a rerun of last year’s battle over whether or not to raise the limit.

Investors express little hope that the U.S. government’s debt overhang will be meaningfully reduced, and they see it as an impediment to economic growth. That pessimism feeds into expectations of continued frequent, sharp swings in stocks and other riskier investments, while interest rates stay locked at extremely low levels, some investors say.

Mr. El-Erian compares the country’s debt overhang to a dark cloud “hanging outside your front door.” While it may not yet be raining, “you may not want to go out and it is perfectly rational for you to wait,” he says.

Lon Burford, a financial adviser at Genovese Burford & Brothers, which is based in Sacramento, Calif., and oversees $1.3 billion, says that is a big reason why he is keeping client stockholdings some 10 to 15 percentage points below the typical allocation for a portfolio. Making up the gap are greater-than-usual holdings of alternative investments and bonds, with an emphasis on short-term and intermediate-term bonds, Mr. Burford says.

“We think that last year’s debt-ceiling fight was just an example of the dysfunctional political circumstances not only in Washington, D.C. but globally,” Mr. Burford says. “The drama that leads up to short-term deals will continue to cause market volatility.”

At Pimco, the view is that Washington and other capitals are too politically paralyzed to come up with effective economic policies. Meanwhile, the Federal Reserve is becoming increasingly ineffective. The result, Mr. El-Erian says, will be continued sluggish growth and low interest rates.

Last year’s clash over the debt ceiling was a catalyst for Jason Trennert, founder of economic research firm Strategas Research Partners, to abandon his two-year long bullish stance on stocks and turn bearish.

A year later, Mr. Trennert says, “Unfortunately, the federal government doesn’t appear to have viewed it as a wake-up call.” That, he says, is largely because the downgrade didn’t impose a lasting financial cost on the U.S. government from investors demanding higher interest rates when buying the country’s debt.

Along with slow growth and Fed policy, a key factor in sending rates lower was demand from global investors who view the dollar a “reserve currency” in which they feel safe holding cash.

With the fiscal’s cliff’s $540 billion in tax increases and spending cuts looming, Mr. Trennert says it is going to be tough for stock prices to post sustained rallies. “You can have swings, but until there is real structural reform … we remain pretty bearish.”

Write to Tom Lauricella at Tom.lauricella@wsj.com