The United States of America (US) and her fiscal policy has greatly impacted capital markets in the past decade, in particular,causing private business to be more difficult and expensive to operate. The capital market impacts include but are not limited to the following: downgrade of US debt by S&P as a result of the budget deficit debates seen in Congress over the summer of 2011; ability of firms to refinance their debt as a result of the cost of US debt dropping to historic lows and; healthcare tax impact on small business. Additional impacts of unknown proportion are anticipated when, at the end of November 2011, the Super Committee of the US Congress charged with reducing the US budget deficient by $1.2 trillion dollars, will announce its policy decisions.
Impact of US Debt Downgrade on Investment Policy Statements
The US debt downgrade’s impact is complex and difficult to measure. However, its biggest impact and most measurable aspect has been on investment plans and investment groups and their investment policy statements. An investment policy statement (IPS) is an agreement between two parties, generally a portfolio manager and a client or similar relationship, outlining the objectives, restrictions, funding requirements and general investment structure for the management of the plan’s assets, Non-adherence to an IPS can result in legal proceedings and fines for the manager.
Healthcare Tax Impact on Small Business
Small businesses are a driver of the U.S. economy by creating jobs, wealth, and building communities. The tax impact of the recently passed healthcare laws are significant on smaller firms because their financial bottom line is impacted faster. This tax impact impedes small business from seeking financing in the capital market because of the cost they must pay to offer their employees healthcare. Small businesses may pay up to 18% more in premium cost per worker than larger firms with the same healthcare offering. These higher costs are felt in the bottom line with lower wages or a loss of overall profits.
Firms Refinance Their Debt Due To Historical Lows In US Treasuries
Since 2007 – US Treasury Bills, Notes, and Bonds are being treated and demanded as risk free assets for firms seeking to finance their projects with greater propensity than perviously seen in the markets. The risk free rate serves the purpose of being a baseline rate of return for all investments. In theory, investing at this rate will offer a return with no risk. This rate is also used in a calculation called the weighted average cost of capital (WACC) which is an academic method for calculating the required return of financing with debt, equity, or some combination of the two.
Cash, Pecking Order Theory
With a 68% reduction in the WACC, firms have been refinancing heavily. When firms can raise capital (all things being equal) with historically low costs firms will make expansions. These expansions can come in the form of mergers and acquisitions, plants property and equipment, or by increasing human capital. For example, in 2008 T. Rowe Price was preparing to hire 1500 new employees. T. Rowe Price did not hire 1500 new employees in 2008 as a result of the liquidity crisis. The firm waited until 2011 to start hiring. It waited to hire because it was taking the chance to clean up its balance sheet – which would allow it to better position itself for future operations. The firm also built two new buildings and updated all of it current facilities. It is logical to assume T. Rowe Price did not hire new employees for over 3 years because they were unsure how long the risk free rate would remain low allowing them to refinance. They wanted to get as much money from the capital markets to meet their needs as long as the funding was prudent for business. It is also interesting to note, T. Rowe Price has grown its cash position by over 20% since 2008 while holding its total liabilities flat. This trend, growing cash, is seen though-out firms in different industries.
The ability to grow cash also affects the way firms will finance new projects. According to the pecking order theory, firms will choose to finance first with internal cash, second with debt from the capital markets, and third with equity from the capital markets. Because many firms are hold high levels of cash, (Apple Inc. is currently holding more cash than the US Government) they do not need to go to the capital markets to finance their projects. This positions many firms uniquely and gives them the chance to pursue mergers or projects previously considered out of reach. This can be seen the the consolidation of the pharmaceutical industry over the past five years.
Impact of Super Committee Decision
In response to the growing budget deficit, a Super Committee, decomposed of members of Congress was formed to make decisions regarding fiscal policy and charged with the duty of reducing the deficit by $1.2 trillion dollars. The decision of this committee will undoubtedly affect the capital markets. The committee has the option to raise federal taxes or cut the federal budget to meet its required goal. However, because this issue is political there is much debate if the committee will come to an agreement. In order for the committee to meet its goal, it must enhance revenue while reducing government spending. If the committee does not come to an agreement than 50% of the $1.2 trillion will be cut from the US defense budget and the other 50% will be cut from non-entitlement programs in the US budget. Whatever the decision of the committee or lack of a decision of the committee, the market’s reaction will be violent.
The market’s reaction will be violent because policy decisions which need to be made are turning into a political debate as next year is a congressional and presidential election. Both parties are taking stances to best align themselves with their voters. These actions will cause the committee’s decision to be made in the 23rd hour as seen in the budget deficit earlier this year. This delay in the decision will increase the volatility of the market as demonstrated with the passing of the 2012 US Budget summer 2011.
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- U.S. Macro Flash, 7 November 2011, Citi, Steve C. Wieting
- Comments on Credit, 11 November 2011, Citi, Robert V. Clemente
- U.S. Rate Strategy Notes, 10 November 2011, Citi, Neela Gollapudi
- U.S. Interest Rate Strategist, 3 November 2011, Morgan Stanley, Morgan Stanley Research
- Credit Outlook: Credit Spreads Appear Fairly Valued, 30 June 2011, Morningstar
- “The Economic Effects of Health Care Reform on Small Businesses and Their Employees.” The White House. Web. 16 Nov. 2011. <http://www.whitehouse.gov/administration/eop/cea/Health-Care-Reform-and-Small-Businesses>.