After the significant stock and bond market volatility Mr. Bernanke set off in May with his remarks that a “taper” of the Federal Reserve’s $85 billion per month bond-buying program was being considered, the third quarter proceeded surprisingly smoothly.  The S&P 500 Index managed, after some mild summer swings, to advance 4.7% in the quarter.  Even the late-quarter grumblings out of Washington failed to knock equities down much. Perhaps investors, after having watched markets dive and then recovery rapidly during both the 2011 debt ceiling debate and the 2012 fiscal cliff fight, decided that Washington would ultimately find a way to compromise before defaulting on our national debt.  They were right—at least this time.

While it may seem counter-intuitive, the mess in Washington actually seems to be helping the equity markets.  It is impossible to parse the specific reasons for a stock market rally, but it is clear that the government shutdown and debt debate in Washington have reduced consumer confidence and weakened economic growth in the near term.  Yet the S&P 500 has been hitting fresh all-time highs since the October 17^th agreement to kick the debt ceiling can down the road by a mere four months.  Why?

Strange though it may seem, weaker economic growth is not necessarily bad for stocks.  In fact, the best historical stock market performance has occurred during times of slow and steady economic growth—not rapid growth.  The primary reason that the debate in Washington provides ballast to stocks is that the pressure on growth and confidence it has caused will likely keep the Federal Reserve from making any significant changes to its accommodative monetary policy.  Mr. Bernanke was on the verge of curtailing Fed bond purchases during the September Fed meeting, but he didn’t—probably because he expected the brewing debate in Washington to cast a wet blanket over the economy.  Now many economists believe it may be as far out as March or June of 2014 before tapering begins.  This delay in the tightening of monetary policy will likely keep bond yields lower for longer, thereby allowing equities (bonds’ main competitor for investor affections) to continue to enjoy support from the Fed’s easy-money policies.  One day growth will accelerate and the stock market will face off against a Fed determined to return short-term rates somewhere close to their historical averages.  But not yet.

With the third quarter earnings season now underway, the markets have turned their attention back to companies and the economy and away from Washington.  But even though the debt ceiling fight is over for now, it has caused significant damage to the economy.  Standard & Poor’s estimates the economy lost $24 billion as a result of the Federal government shutdown, but the losses are far from tallied and indeed continue to build even today.  Consumers and businesses alike have lost considerable confidence in our lawmakers, undoubtedly causing many to postpone hiring decisions and capital expenditures.  The fact that we may be gearing up for a re-run of the debt ceiling issue early in 2014 will likely have a significant negative impact on fourth quarter GDP—perhaps knocking 0.3% to 0.6% off the economic growth rate for the quarter.

The announcement that Janet Yellen is to take over leadership of the Federal Reserve in January has also brought comfort to equity investors.  Along with a reputation for clear communication, Ms. Yellen is also considered to be dovish from a monetary perspective.  This means she is concerned about how Fed interest rate policy affects workers in the U.S.—especially those who are unemployed.  Thus, if her future actions remain consistent with the views she has espoused in the past, investors can expect the Fed to maintain an accommodative monetary stance if the economy continues to remains sluggish and job growth remains on its current low trajectory.  Washington’s woes won’t help the economy grow, but they will help interest rates stay low, thereby supporting both bonds and stocks.