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Debt deal: What our experts think

The debt-limit crisis was averted, but the stage is set for fiscal battles down the road.

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A sigh of relief echoed through financial markets with the passage of a law extending government funding and suspending the debt ceiling. Federal agencies will reopen, with a continuing resolution to fund the government until January 15, 2014. The debt ceiling will also be suspended through February 7, 2014.

While the bipartisan agreement was welcome news in an otherwise gridlocked Congress, it only provides short-term relief. So what can investors expect as the next chapter in the budget and debt saga unfolds? We checked in with three Fidelity experts to get their outlook on what the deal means for markets and investors, now and in the future.

What many thought would be a routine fiscal debate ending in a last-minute deal turned into political gridlock that partially shut down the government for more than two weeks, and put the United States on the brink of a debt-limit crisis. The path forward was difficult, but the House and Senate have finally passed a bipartisan agreement to reopen the government and raise the debt ceiling. The deal averted an immediate debt-limit crisis, but sets the stage for more fiscal battles in the weeks and months ahead.

The new law extends government funding until January 15, 2014. Congress must pass another continuing resolution before that date to avoid another partial government shutdown. This short-term deal gives lawmakers another opportunity to debate the sequester before additional spending cuts are triggered.

The new law suspends the debt limit through February 7, 2014, but allows the Treasury to use its debt-management tools to issue new debt beyond that date. This means Congress will gear up for another debt-limit battle just a few months before the midterm elections. It also alters the health care law by requiring the government to verify that individuals claiming health care subsidies are truly eligible for those subsidies. Finally, it provides back pay to furloughed government workers and reimburses states and other grantees who paid to keep government services operating during the shutdown.

Congress reached an agreement to extend the debt ceiling and avoided what could have been significant stock and bond market volatility and sell-offs. Now that the situation has been resolved—at least temporarily— investors can once again focus on economic growth and corporate earnings.

But damage was done in the process. Global investor confidence was shaken as policymakers widely discussed the possibility of a default. Short-term Treasury rates rose sharply out of fear of a potential default, despite the fact that these securities are viewed as “risk free.” And yet another ratings agency, Fitch, placed the United States on “Rating Watch Negative” because of the prolonged brinkmanship. The next debt-ceiling debate could once again sorely test the patience of investors and ratings agencies.

Next up, a slew of economic data, delayed because of the government shutdown, will be released and will likely impact financial markets. Investors should closely monitor the September unemployment data, retail sales, and consumer prices. This data will likely be released all at once in the coming days, and it could affect stock and bond markets, as well as the economic outlook. Data that is stronger or weaker than expected will once again cause investors to focus on what the Federal Reserve will do.

Investors should also understand that the Treasury now needs to replenish about $200 billion in emergency funds it used to continue borrowing since May. The Treasury will do this over the next few days. As a result, the overall national debt will jump immediately from $16.7 trillion to more than $17 trillion by next week. This significant jump could raise some eyebrows regarding the growing debt. However, this has always been the case—after the Treasury issues its emergency fund during the debt-ceiling period, it needs to pay it back, which leads to an immediate increase in the debt.

More broadly, the debates do keep the national conversation regarding fiscal issues in the limelight—which is good. While frustrating, the more engaged the public is in the debate, the greater the chance of continued incremental progress in addressing our long-term debt problems. Congress could end up discussing longer-term structural reforms as a result of this impasse. Believe it or not, we’ve seen a lot of fiscal progress over the past 18 months.

In fact, the U.S. Treasury is starting to issue less debt as a result. For the first time in six years, the U.S. Treasury cut the size of a Treasury issuance. In August, the Treasury cut its two-year note issuance from $35 billion to $34 billion, and this month it reduced its three-year issuance from $32 billion to $31 billion. These reductions seem small, as a percentage of debt, but the Treasury doesn’t cut issuance lightly—only when it anticipates a one-, two-, or three-year decrease in borrowing.

So it’s not all bad news out there. Investors may want to focus more on the Federal Reserve’s monetary policy, economic growth, and the improving fiscal situation, now that the storm has passed for now.

The good news is that the economy, which is the starting point for market behavior, is getting incrementally better—both in the United States and around the globe. The housing market has been a source of strength, and the employment markets have continued to improve. Consumer credit has eased, and tax revenues have picked up.

The fiscal backdrop has also improved significantly. If you think back to mid-2009, the deficit was near 10% of GDP. Fast-forward to today, and the Congressional Budget Office (CBO) is predicting the deficit will be more like 4% by the end of the year. Because of the sequester and other fiscal consolidation, we’ve seen a lot of fiscal drag (reduction in economic activity due to higher taxes and decreased government spending), but it has come at a time when the economy is becoming more sustainable in its expansion, so it has been able to weather it. We’re actually looking at less fiscal drag in 2014 than we had in 2013.

Nevertheless, the government shutdown has been negative for business, consumer, and investor confidence. The shutdown reinforced that Washington is having a hard time accomplishing even the most routine of tasks such as passing a budget. The shutdown has had a direct negative economic impact as well, with some federal workers furloughed and businesses that interact with government agencies facing interruptions. However, the economic damage will likely not be devastating, particularly if the shutdown is not prolonged.

In the near term, the relatively benign fiscal and economic picture is insulating us somewhat from the negative headlines around the latest dysfunctionality in Washington. That doesn’t alleviate the very serious long-term problems we face. We haven’t done anything to address entitlement spending or to put the U.S. budget on a sustainable long-term fiscal trajectory. But the budgets for this year and next are in a much better position than they were a year ago.

It is important to remember that other factors also have the potential to affect the markets. Investors are uncertain about how the Federal Reserve will approach the tapering of quantitative easing, so we can probably expect higher volatility to continue through the fall—but the fiscal debates are likely to be only one of the drivers. And any volatility comes within the benign context of a steady economic backdrop, without a lot of inflation.

In general, the environment is not bad for economically sensitive assets such as stocks. European stocks in particular have become very inexpensive, and Europe seems to be coming out of recession. As for bonds, they are in much better shape than they were several months ago, and the near-term outlook has become more balanced. Still, over the next couple of years, I think rates are likely to rise, creating a headwind for fixed-income assets.

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