Last week, on Bastille Day, I wrote "The Seven C's of Recovery Optimism" to highlight fundamental driving forces that would propel the S&P 500 to 1,500 in the first quarter of 2012. An investor wrote me a comment in response, asking the following questions…
"What about C for Compromise? I'm worried the Republican House members won't compromise with the Dems and our government will default, and who can tell how badly that will affect the markets? Any thoughts?"
Great question, and of course I have thoughts. Here's what I wrote in response:
"Yes, the debt ceiling drama is a big deal… in the short run. When I wrote my original seven reasons in March of 2010, my number one was actually 'We've seen sovereign default risk, and we are not afraid.' It has proven very true. Just look how much higher the market has been since the mud of Europe's PIIGS first started getting flung… the S&P is 200 points higher since then."
The debt issues for both Europe and the US are serious matters. But they won't derail global growth in my humble, amateur-economist opinion. As I wrote in "Slowdown Looks Entrenched" on July 8 after the terrible jobs number, "the political battle in Washington is just some necessary complaining and grandstanding that needs to happen. Far smarter minds behind the scenes from the world's major central banks will not let the US fail to keep its promises."
China Behind the Scenes
Case in point, to prove my point, surfaced overnight with an official statement from the Chinese government. Writing for The Financial Times from Beijing, Simon Rabinovitch well summed-up the sentiments of the central bank with the world's largest foreign exchange reserves in his opening sentence:
"China has called on Washington to bolster international faith in its economic policies amid signs that Beijing has cut its purchases of US government debt."
This was part of a public response to questions on the website of the Chinese State Administration of Foreign Exchange (SAFE) about the impact on China's current Treasury holdings, and future purchases, if the US debt ceiling issue is not resolved and the risk of default, or even a country downgrade, becomes real.
China-US Trade and Debt Symbiosis
As I've said for years, the risk of China reacting to such threats with large-scale selling of Treasuries is very remote. They would only be hurting themselves by initiating a spiral collapse of the US dollar and Treasury debt. Since over two-thirds of China's massive $3.2 trillion in currency reserves is in dollars, it is always in their best interest to support the dollar and US Treasury securities.
This symbiotic relationship is largely an after-effect of the other two forces at play here: China's economic dependence on exports to the US, and the yuan currency peg which sustains their competitive trade advantage. They have to put dollars back into Treasuries because there isn't enough gold, oil, copper, or wheat to withstand their buying power.
This said, China would still suffer even if they did no selling and were the victims of a downgrade to US debt by ratings agencies like Standard & Poor's and Moody's which have issued warnings of the possibility. Chinese financial leaders are very conscious of this threat, as evidenced by this direct call on the SAFE website:
"We hope the US government will earnestly adopt responsible policies to strengthen international market confidence, and to respect and protect the interests of investors."
While this is a formal political posture to be sure, you can be sure that many back-room conversations between SAFE and the US financial authorities have been occurring to assuage and assure our biggest creditor. The full FT article, "China calls on US to protect investors" is worth reading for details on whether or not China has recently slowed its Treasury purchases.
Woe to the Underinvested Portfolio Manager
So, should I add "Compromise" as the eighth to my list of "The Seven C's?" I still don't think so. The compromise in Washington is unfolding about as I thought was likely and this sovereign debt issue, though crucial in the sense of not being an obstacle to the market advance and economic expansion, is not a driving force behind them.
I heard my friend Jim Cramer before the open this morning talking about the stock surge yesterday. Actually, I don't really know Cramer, but I did write for TheStreet.com for nine months before I came to Zacks. More importantly, I was daily reading Jim's hedge fund trading blog as early as 1997, before the word "blog" even existed. He taught me as a new investor-trader how Wall Street really worked.
Anyway, he proposed this morning that money managers probably became cautious in the past few months while navigating the uncertainty of Europe and the brewing US debt high-noon. He thinks many may have gone to a neutral 50/50 allocation posture in their portfolios and could now feel "underinvested" as stocks with monster earnings are making the whole market run away from them. See my piece from yesterday, "Apple: Why You Still Buy the Dips in Earnings Machines" on how earnings monsters like Apple (AAPL), Caterpillar (CAT), Chipotle (CMG), priceline.com (PCLN) and Netflix (NFLX) make fortunes for investors who follow them.
Cramer mused something like this… "What if they now have to shift back to 60/40 in favor of stocks?" I love when the "bull train you can't catch" gets away. It's what drove stocks for most of 2009 and 2010 when I explained to my readers why PMs have to buy stocks. And it's not over.
Next time, I'll expand on the "cash is trash" theme and write more specifically about what happens when the flood of cash in bond funds makes a surge for stocks.
Kevin Cook is a Senior Stock Strategist for Zacks.com
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