Monday, October 7, 2013

The Debt Ceiling Debate: A Possible Repeat of 2011?

In this piece, I will update everyone on the current situation in Washington regarding the government shutdown and the debt ceiling debate. Given both parties are publicly attacking each other and negotiations to re-open the government failed to yield any results, investors should not be expecting a smooth negotiation to raise the $16.7 trillion debt ceiling. Treasury Secretary Jack Lew already stated that by October 17th, the Treasury would only have $30 billion to pay claims including interests on debt.   

One party Zigs, other Zags:

Because of political differences, the U.S. government had to shutdown last Tuesday because of the U.S. congress's inability to pass a funding bill to fund the government for the new fiscal 2014 year. (U.S. government has fiscal year ending September 30). Republicans insisted on delaying the implementation of Obama's Affordable Health Care Act (Obamacare) as a condition to pass a funding bill. Democrats did not yield to Republican's demands and merely blamed Republicans for the cause of the shutdown. It is clear that each party is using this opportunity (government shutdown & debt ceiling debate) to try to lay blame on the other party and to seize some political gains for the upcoming election (mid-year election next year for the house/senate and 2016 Presidential election). Furthermore, Republicans already conceded too much in the last budget debate on New Year's eve that led to the sequester. Therefore, Republicans wanted to act tougher this time to force the Democrats to concede more during this round of budget debate. 

Given the hard stance taken by the two parties publicly, it is difficult to reconcile the two parities and form an agreement to open the government. Also, the vote to increase the debt ceiling appears more difficult given politicians can't even agree to end the government shutdown. The political game of chicken is starting to look awfully similar to 2011 and may have similar consequences. 

U.S. Won't Default, But That is Not What Investors Should Worry About: 

Yes, I can safely assure investors that U.S. won't default on its debt. Given U.S. treasury yields are used as benchmark yields for almost every financial instrument and the U.S. dollar is also the reserve currency, politicians know they can't risk a default, no matter how small it is. The effects of such a default would be unimaginable. For those who are curious, yields on treasuries would soar (not a safe haven anymore!), stocks prices would tumble and foreign investors may attempt to exit their U.S. investments. The consequences of these actions will trigger a long recession or even depression if policymakers do not act quickly. 

Let's move away from the doomsday scenario to a more realistic scenario.  The U.S. will not default, but politicians will continue to avoid making progress on discussions until the last minute regarding the debt ceiling. As the October 17th deadline date approaches, investor confidence will slowly erode to reflect a rising probability that politicians may fail to reach an agreement by the 11th hour. The erosion of confidence will be detrimental to the financial markets. Stocks will face some short term headwinds and bonds yields will decline due to the safe haven trade. 

Current investor sentiment is high because of the Fed's commitment to keep rates low (accommodative monetary policy) and the continuation of its asset purchase program (QE3). Nonetheless, history has provided many evidences where confidence can erode quickly. As investors saw in 2011, the debt ceiling debate suddenly went sour 2 days before the deadline and investors quickly dumped all risky assets (such as stocks) to avoid a potential U.S. default. When investors are nervous, emotions will take over. This means that anxious investors will sell everything because they only care about the return OF their capital rather than return ON their capital. Investors must realize that they are creatures of emotion, not creatures of logic especially in times of uncertainty. T-bill investors are already anxious enough to push the yield on T-bills due in late October from 0% to 0.13%. The CDS market is also showing some signs of stress with the cost of U.S. CDS rose to 64 bps from 30 bps. 


Investment Strategy:


In times of uncertainty, cash is king. Keeping some cash on hand is wise especially if markets will react negatively if negotiations continue up to the 11th hour of the debt ceiling deadline. Markets are not worried now because they assumed the debt ceiling will be raised and the agreement would be amicable. However, the final agreement on the debt ceiling would be far from amicable and investors' anxiety will increase with each passing day. More anxiety will likely lead to a market correction in the short term despite the U.S. congress will eventually raise the debt ceiling.

While it is possible for a debt ceiling agreement without creating too much investor anxiety, markets would hardly respond at all to a positive outcome because it has already been "priced in". However, markets will decline if negotiations become too hostile. Hence caution is warranted for now. 

Going back to the question I proposed in my title, it is quite possible for a repeat of 2011. However, equity market declines are likely to be much smaller than the 19% experienced in 2011 because of the Fed's stimulus and better economic conditions. Nevertheless, if the U.S. congress fail to raise the ceiling by the deadline, a 5-10% equity decline is definitely possible. Market declines are actually good for investors because they allow prudent long term investors to add to their positions when prices are down. Unlike most investors, I welcome market declines -especially large ones like 50%- so I can buy additional shares of the companies I own. If everyone likes big discounts when they go shopping, they should learn to appreciate market declines the same way. 

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