WinnCad Elements Blog: After debt deal, economy in deeper peril

It's not over. Not by a long shot.

If the Senate Tuesday approves an 11th-hour budget deal to lift the debt ceiling, as expected, and head off a national default, forget those high-five photo ops and victorious press conferences. The spectacle of partisan bickering by a dysfunctional government will continue to weigh on consumers, investors and business for months to come.

That uncertainty will also further dampen economic growth — the most powerful remedy for the nation’s fiscal problems.

“This deal sets us up for acrimony and additional fights all the way until the elections,” said Charles Gabriel, a budget analyst at Capital Alpha Partners.

Story: Many questions linger over debt and deficit accord

After multiple failed attempts to agree on a package of spending cuts and increased borrowing authority, the House last night sent to the Senate a two-step plan. In exchange for $917 billion in spending cuts over 10 years, the debt ceiling would be lifted by $900 billion — not enough to fund the government through the 2012 elections.

Additional borrowing authority would require another $1.5 trillion in cuts worked out by a new congressional panel, which must agree to those cuts by late November. If the panel deadlocks or can’t come up with at least $1.2 trillion in cuts, the Treasury would only get $1.2 trillion in additional borrowing authority; the defense budget and payments to Medicare providers then would be automatically cut by that amount.

Story: Debt bill passes Senate, Obama signs it

And Congress has yet to authorize spending for the next fiscal year.

All these future deliberations provide multiple opportunities for a repeat of the brinkmanship and fractious debate over where and how deeply to cut government spending.

“The government is only funded through the end of this fiscal year, Sept. 30, so we've got that whole fight in coming back online,” said Jeff Kleintopp, chief market analyst at LPL Financial. “The $1.5 trillion in automatic (spending cuts) is going to be voted on two days before Christmas.“

Story: Debt deal puts off major changes to the future

And the debt ceiling deadline will loom once again if Congress fails to approve the recommendations of the special joint committee.

“Failing that (agreement), the president will only be able to extend the debt ceiling by $1.2 trillion early next year,” said Gabriel. “And that won’t even get you to the elections. So you could have these same headlines and histrionics just before the election.”

All that political posturing has not been good for the economy. Consumers, investors, and business owners and executives have watched in horror as their government used the threat of an unprecedented default as a political bargaining chip.

As long as that uncertainty continues to hang over the economy, confidence could continue to erode.

“Partly because the Congress and the president have been in the news and all the acrimony around it confidence, which was low, has fallen further,” said Blackrock chief equity strategist Robert Doll.

Little solace

The latest economic data offer little solace.

On Monday, a widely watched measure of manufacturing activity fell further than most analysts had expected to levels not seen since the end of the recession. Friday’s report showing the economy grew just 1.3 percent in the second quarter and a negligible 0.4 percent in the first quarter reinforced the notion that the recovery is tenuous.

Slower growth means a slowdown in corporate profits, which have propped up the stock market through the months of uncertainty over debt ceiling. Now, with spending cuts looming, and the economy closing, investors are reworking their profit estimates for coming quarters.

“How long can you produce GDP that's below 2 percent — below 1 in a recent quarter — and have earnings growth and revenue growth as good as it's been?” said Doll. “That can only last so long.”

Slower growth is also taking its toll on the job market. The latest employment data, due Friday, is expected to show that fewer than 100,000 new jobs were created in July. That’s less than what is needed just to keep up with the regular expansion of the work force.

High unemployment makes it even harder to close the budget deficit. States are already straining to cover the cost of unemployment insurance claims. Spending on Medicaid and food stamps, which are exempt from the budget deal, also typically rise as the jobless rate goes up.

“With a 9.2 percent unemployment rate, you’re not going to be able to make big dents in the deficit. It’s just not going be able to happen,” said Jason Trennert, chief investment strategist at Strategas Research Partners. “Transfer payments will be too large. Government will still be too large to make significant progress.”

As the budget talks ground on, there was little priority given to measures designed to revive economic growth. One of the major failures was the abandonment of the task of reforming the badly broken tax code. House Republicans adamantly opposed tax changes in the final deal.

"The president's bipartisan commission made some very, very sensible proposals, ways to try to eliminate some loopholes that would allow more revenue to come in, at the same time by reducing tax rates, reducing distortions and increasing growth," said Randall Krozner, a University of Chicago economist and former Fed governor. "So there's an opportunity here to actually get something really good on the tax code."

Tax changes?

The White House already is pressing for changes on the tax side of the ledger. On Monday, White House press secretary Jay Carney told reporters president Obama will continue to push for an extension of the payroll tax cut.

"He will make the argument that it is absolutely essential to continue to put extra money in Americans' pockets as they deal with high energy prices and high food prices next year," he said.

The proposed budget deal also does little to lift the cloud of uncertainty over the U.S. government’s top-notch AAA credit rating. Credit rating agencies have said they won’t act until any budget deal becomes law. But Standard and Poor’s warned in a report in March that without a “credible” deficit-reduction package of roughly $4 trillion over 10 years, the government’s rating would be subject to a downgrade. Even if the bipartisan committee agrees to targeted cuts, the total will fall short of $2.5 trillion.

“There's no ambiguity in that report,” said Barry Knapp, market strategist for Barclays Capital. “If we don't get to the $4 trillion number, they won’t (affirm the AAA rating.) It's written in such a way that they could still downgrade with a $4 trillion number."

Since credit raters Moodys’ and Fitch also warned of possible downgrades, economists and market analysts have debated just how much impact those downgrades would have. The worry is that investors would demand higher interest rates to buy U.S. Treasuries. But so far, rates have held steady.

“Even if they were to decide to make this call for a downgrade, I don't think it would have dramatic consequences,” said Krozner. “Because even though we would then have the same credit rating as Slovenia, I don't think market participants are going to treat Treasury securities as a perfect substitute for Slovenian securities."

Even if those rating downgrades don’t happen, investors get the last word on whether they are confident the United States can get its budget in order. Under the proposed budget deal, the ratio of debt to GDP is still growing. If the economy continues to slow, or heads back into recession, that ratio moves even higher.

“It's important to separate the current crisis about the debt ceiling limit with the real issue and the more important issue, and that is the balance sheet and the spending obligations of the U.S. government,” said investment manager Bernard McGinn. “At the end of the day what’s happening today will be forgotten a month from now. But what won’t be forgotten a month from now is the balance sheet and spending obligations of the U.S. government."

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