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AMP Capital Investors Limited ABN 59 001 777 591, AFSL 232497

Here we go again…

US political gridlock and its implications

3 OCTOBER 2013

Two separate but related US political issues have the

potential to unsettle financial markets in the immediate

period ahead. To date, global markets appear to be taking

the current US political theatre in their stride given

increasingly supportive global economic fundamentals.

US Government shuts down non-essential services

The first and most immediate issue for markets is the US

Government shutdown of non-essential services that has

now taken effect. The US Congress has missed its 30

September deadline to pass legislation that authorises the

provision of funding for government programs during the

new 2014 fiscal year (commencing 1 October, 2013). The

US Senate (Democrat-controlled) has passed legislation

authorising funding but the House of Representatives

(Republican-controlled) has rejected it because they do not

support President Obama's new healthcare bill, known as

Obamacare. Republicans will only agree to approve a

temporary spending bill in exchange for concessions on the

healthcare bill, which they view as wasteful and oppressive

as it requires most Americans to have health insurance1.

It is estimated that up to 800,000 government workers could

be laid-off until Congress approves US Government funding

or at least reaches an interim compromise to buy more

time. Meanwhile, services deemed ‘essential’ will continue,

among them those related to national security, mail delivery,

air traffic and law enforcement.

A shutdown is not a new thing with the last occurring in mid-

December 1995, under President Clinton. In fact, there have

been 17 shutdowns between 1976 and 1996 although they

were most common in the 1970s and 1980s.

It is difficult to know how long the current deadlock will

last. On its own a short-term temporary closure of

government services has not historically been a major issue

for financial markets (although it is certainly important for

those employees immediately affected).

1 Victoria Craw and AAP, What happens if the US Government shuts down?,

News.com.au, October 1, 2013, 6:52PM

However, a potentially larger issue is the risk of a more

profound disagreement over the need to raise the US

Government’s borrowing limit, the ‘debt ceiling’.

The US Government is quickly approaching its debt ceiling

The US Government’s limit on borrowing is currently set at

US$16.7 trillion. As the government is running a budget

deficit (currently around 4% of GDP) it needs to borrow to

continue to fully fund its operations. The US Treasury –

responsible for arranging these borrowings and debt

repayments – has indicated that its ability to borrow may

end on 17 October.

A failure to agree a lift in the borrowing limit is potentially

much more serious than the current shutdown as it would

mean that the government would automatically be required

to balance its budget. Unable to borrow any more money to

fund its operations or refinance existing borrowings, it would

need to draw from government revenue sources. The

government would also run the risk of defaulting on its debt

repayment obligations.

What has been the market reaction?

As the US political process runs it tortuous course, investors

will be interested in:

> How long US Government services will be shut down;

and

> Whether the US Congress can reach an agreement to

increase the Government's borrowing limit.

For now, markets do not appear to be reacting adversely,

but market sentiment can change quickly. If markets formed

the view that a government shutdown could endure for

longer than expected, there is a risk of a decline in investor

confidence. This may reflect a fear that something

unfortunate could occur which could unhinge US growth

from its current recovery path and thereby affect US

corporate earnings. US corporate earnings remain one of

the key strengths of the US economy; providing a solid

fundamental underpinning for the market’s impressive gains

over the past year.

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Nonetheless, some signs of more cautious global investor

sentiment have encouraged a decline in bond yields,

particularly in the US market. As a result, we believe that

there is the potential for increased short-term volatility in

financial markets.

The action taken by US politicians in relation to the duration

of the government shutdown and the lifting of the debt

ceiling will have implications for investor sentiment. It is

important to note that in this case, markets may not react to

the shutdown itself but to the debt ceiling negotiations.

Global outlook

Despite US political gridlock, the fundamental global

economic backdrop is improving:

> Stimulatory monetary policies remain supportive of

equity investing;

> Moderate US growth is continuing;

> Europe finally appears to be recovering with growth

returning, albeit slowly;

> Japan is growing with the help of strong policy stimulus;

and

> China's economy looks to be in a stronger position than

earlier this year.

Globally, monetary policy remains highly stimulatory and

this is likely to remain the case for the foreseeable future.2

Indeed, the US Federal Reserve has recently decided to

continue with the purchase of financial assets to the tune of

US$85 billion a month under its open-ended quantitative

easing program and its effective zero interest rate strategy.

This strategy has underpinned US equity gains with the

Federal Reserve indicating that it plans to keep the strategy

in place so long as it perceives risks to US recovery, such

as those resulting from the inaction of US policymakers.3

What does this mean for investors?

Equities are at risk of increased volatility in the month ahead

as the US budget and debt ceiling negotiations continue.

However, any downturn in equity markets is likely to be

temporary in nature. Equity valuations remain reasonable,

stimulatory monetary conditions are set to remain and as

Australian growth picks up, profits are likely to follow suit. By

2013 year-end, the potential exists for upside in global and

Australian equities with gains continuing into 2014.

Perhaps one disappointing feature of the current US fiscal

bottleneck is that the potential for further upward re-rating of

share markets does depend on clarity in fiscal policy

settings by politicians globally. Whilst monetary policy

globally is doing its part to support more secure growth, the

2 The Economist, Monetary policy after the crash, controlling interest, 21 September,

2013 3 Federal Reserve, Press release, 18 September, 2013

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lack of clear fiscal policy frameworks in the US could remain

a source of ongoing medium-term concern.

Final thoughts

It is unknown for how long the partial shutdown of the US

Government will continue, but it goes without saying that the

longer the shutdown remains in place, the larger the

potential impacts on US growth. If it is over relatively quickly

its impact on the US economy should be very limited and no

more than a passing distraction.

We believe that US politicians will agree to raise the US

debt ceiling before the 17 October deadline. However, until

that we expect equity markets to experience heightened

bouts of short-term volatility.

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.