Fork In The Road: The US Debt Ceiling Impasse
In the last several days the volume of calls have increased and the common question is "Should I go to cash?"
The way I see it, there is only two ways for this to ultimately turn out. Either the government will come to a compromise and raise the debt ceiling, or they won't.
I put the odds of the government letting the August 2nd deadline come without a resolution to the matter at "very unlikely". There is simply too much for both sides to lose. The only question is how both sides can emerge from the mess they have created, and still declare themselves the winner.
As an investor you have a choice. The market has declined quite a bit this week as uncertainty worked its way into pricing. Selling now and going to cash, you have protected yourself from a potential meltdown next week but you are also locking in the losses. Frankly, if you were to go to cash, the time to do that was about two weeks ago.
I believe that once a compromise is reached in Washington the markets will respond positively. If you are in cash you will miss out on that opportunity to grow or at least recapture the recent declines. Given that I think a political compromise is the most probable outcome, I am making no changes to portfolios unless a client specifically directs me to.
The Fund Evaluation Group, LLC released this summary, perspective, and recommendation yesterday:
July 28, 2011
The following email describes FEG's perspective on the U.S. debt ceiling impasse and our recommendation that clients stay the course with their existing portfolio allocations.
This week the U.S. Congress continued negotiations between its two major political caucuses and the Obama Administration on conditions for raising the United States' legal borrowing limit (i.e., the debt ceiling). The conditions being negotiated include the magnitude of potential spending cuts and/or revenue enhancements targeted to reduce the Federal budget deficit and the size of the debt limit increase, which in turn will dictate how quickly the Administration and Congress will have to start debt ceiling talks all over again. The stakes during these negotiations are especially high because the major credit rating agencies have threatened to downgrade the United States' AAA credit rating.
While Congress has raised the debt ceiling on sixteen previous occasions since 1993, negotiations this time have been particularly challenging as House Republicans hold out for significant spending reductions.
The U.S. hit its borrowing limit on May 16, at which time U.S. Treasury Secretary Timothy Geithner announced he would suspend contributions to Federal retirement funds. The Treasury Department has implemented other measures to keep total borrowing under the legal limit, but it says the U.S. will be forced to default on its financial obligations if the debt ceiling is not increased by August 2.
With the August 2 deadline fast approaching, we would like to share FEG's view on potential ramifications for client portfolios.
First, it is important to recognize the U.S. debt ceiling is a self-imposed political constraint enacted by Congress. Unlike Europe where there is a real debt crisis, the U.S. version is completely manufactured. Congress and the Administration already passed a budget for fiscal year 2011 so the approximate increase in the deficit was well known and the amount of additional borrowing needed to offset the deficit was also transparent.
Comparisons to Greece's debt situation are inevitable, but the differences between the U.S. and Greece (and other European Union nations) could not be more stark. The U.S. issues its own fiat currency and its debts are denominated in that currency. That means it is physically impossible for the U.S. to default on its debt unless it chooses to do so willingly. It can always print more currency to make interest payments and pay down debt.
Furthermore, the U.S. does not issue debt or raise taxes in order to have money to spend. Under a fiat currency system, it spends electronically by debiting bank reserves and checking accounts. With a fiat currency, the only reason to issue debt or raise taxes is to manage the money supply so as to avoid inflation. Consequently, the U.S. is not going to run out of money and it can easily meet its financial obligations if Congress and the Administration so chooses.
That is why we believe S&P's and Moody's credit rating for the U.S. is not really an outlook on the nation's solvency but more an opinion on the nation's political process.
Meanwhile, Greece, as a member of the European Union, does not control its own sovereign currency, and consequently, has no means of paying outstanding liabilities, which are denominated in the euro, unless it raises tax revenues or imposes massive spending cuts. Greece and other peripheral European nations face real debt crises, while the U.S. short-term debt crisis is artificial. Debt ratings in Europe truly are a reflection of those nations' solvency.
The bond market understands the difference between Greece and the U.S. without the help of the major rating agencies. That is why weeks before the potential default of both countries, two-year bonds in Greece are yielding over 27% while in the U.S. they yield a meager 0.4%, although volatility in the U.S. has recently picked up. 1
A second important consideration is the August 2 deadline is not firm. Again, with a fiat currency the constraint is not when will the U.S. run out of money, as it certainly will not. The real constraint is when will the U.S. Treasury Department no longer have the political authority to spend because the U.S. has hit its self imposed debt limit and tax receipts are no longer sufficient to offset expenditures. By offset, we mean from an accounting perspective not a cash flow perspective.
The debt ceiling was reached in May, and since then the Treasury Department has deferred some expenses in favor of others. With an estimated $29 billion in interest on the debt due in August compared to an estimated $200 billion in tax receipts, it remains unlikely that the Treasury Department would elect to not pay scheduled interest payments and incur a default. 2
Still, having already reached the debt limit, the Treasury Department will be forced to defer more and more financial obligations. It is these ongoing deferrals and the severity and timing of reductions in government expenditures that gives us concern and potentially has negative consequences for risk assets.
The deficit as a percent of GDP remains extraordinarily high because the private sector is still in recovery mode. During the recession, tax receipts plummeted as corporate profitability and household incomes fell while government transfer payments increased due to high unemployment. Additional stimulus measures were also taken to jump-start the economy. Only recently have tax receipts begun to recover and expenditures decline as a percent of GDP.
Consequently, there is a risk that the recovery will falter if government cuts are both significant and accelerated and the private sector does not step in to fill the void. A significantly higher tax burden could also hurt the recovery. Given that households continue to struggle with high debt burdens and miniscule income growth, the corporate sector will need to replace the drop-off in government spending through capital investment and hiring. Perhaps corporations are hesitant to invest due to the uncertainty regarding the U.S. fiscal situation, which is all the more reason Congress needs to act expeditiously to raise the debt ceiling.
We continue to believe the risk of U.S. default is low. Congressional negotiations have focused more on timing and the size of a debt ceiling / deficit reduction package rather than whether one should be passed at all. Only a few have suggested the U.S. should not raise the debt ceiling.
Nevertheless, political brinkmanship can go awry so a default is still a possibility. The ripple effect and unintended consequences of a default and/or credit down grade is what is most disconcerting. Given the complexity of financial markets and proliferation of derivative securities, such as credit default swaps, no one knows the potential cascade of secondary and tertiary consequences such a default/downgrade could set in motion. When the risk-free rate is no longer risk-free because Congress did not raise the debt ceiling in time, the market reaction could be quite volatile, particularly if there are forced liquidations and/or settlements of securities and derivatives priced off of or tied to formerly "risk-free" Treasuries.
On the other hand, a successful resolution of the debt crisis could be favorable to capital markets.
That leaves investors in the uncomfortable position of deciding whether to reduce risk to mitigate a low probability, highly politicized event with unknown consequences of uncertain duration. These types of unknown unknowns are typically dealt with through diversification.
Therefore, FEG recommends long-term investors stay the course for now. If the economy shows signs of contracting and/or market sentiment deteriorates, we will work with cli
ents to take appropriate portfolio actions.
1 Bloomberg
2 "Debt Limit Analysis", Bipartisan Policy Center, July 2011