Debt Crisis Update
We are less than a week away from the self-imposed August 2nd deadline for the United States to increase its debt ceiling from the current $14.3 trillion. The United States has imposed a debt ceiling limit since 1917 as one of several ‘checks & balances’ for its political system.
Over the years, various administrations have quietly increased the country’s borrowing limit with regularity, including a ceiling increase in each year of the past 10 years. So what’s all the fuss about this time around? The ongoing negotiations between the Republicans and the Democrats are far more about political grandstanding than it is about the economics. Aside from an 11% budget deficit putting the coveted AAA credit rating in peril, the biggest difference is that these negotiations, the political gamesmanship, and the partisan tactics are on full display in a very public theatre.
Normally these discussions would be had behind closed doors until a final deal was struck. This time, the American public and the investing public are attending ‘the show’. Canadians need to pay close attention to the outcome due to the deep integration of our two economies. The following outlines some of the possible scenarios that may unfold as we move towards an August 2nd agreement.
According to the U.S. Treasury, the American government will run out of money on August 3rd and will then have to cut government spending, sell government assets, or default (miss coupon payments on U.S. Treasuries). We think a default is the worst case scenario and we believe a deal to increase the debt ceiling will be struck, likely at the eleventh hour. We do not believe a last-minute deal will go anywhere far enough to address the long-term fiscal issues plaguing the country which makes a credit rating downgrade a likely outcome in the weeks or months ahead.
According to Standard & Poor’s, those troubling fiscal issues will require a combination of spending cuts and tax hikes in the $4 trillion range over the next ten years. So far, the proposals from both sides fall far short of this level of fiscal responsibility as the major issues (social security) are not likely to be tackled until after the 2012 presidential election.
We realize some of our assumptions could end up being wrong but we thought it would be a worthwhile exercise. This report is not meant to express or emphasize a political philosophy or support a political party whatsoever. Our comments, we hope, will reflect more fact than opinion.
Possible U.S. debt scenario outcomes and the implications for the markets, economy:
1. Debt ceiling extended
We assume (and hope) politicians see the importance of raising the ceiling so the federal government can meet its immediate obligations and avoid a default. While a default is a worst case scenario, the lack of a longer-term plan to improve public finances and a weak agreement to raise the ceiling increases the likelihood credit rating agencies will downgrade the U.S. Simply put, the United States is deep in debt and lacks a tangible plan to get out of it. Today, total U.S. government debt obligations-federal, state, and local government– are currently 99% of total GDP which is higher than that of Portugal. America has the worst cyclically adjusted primary budget deficit of all the major economies at 6.4% according to the IMF. To us, the evidence suggests the odds of a credit downgrade are better than 50/50.
Should a downgrade occur, there is a likelihood some international investment funds would flee treasuries as they may be prohibited from investing in anything less than AAA-rated paper. Domestically, a downgrade would affect collateral on loans, raise consumer borrowing costs on credit cards, and negatively affect bank capital ratios. Several nations, including Canada, have dealt with credit downgrades in the past but none of the major economies have had the same reliance on foreign capital as the United States does. That said, removing the overhang and striking a deal would cause equity markets to rally 3-5% on the news.
The U.S. dollar would likely strengthen and gold and silver could see some profit taking following their recent price surges. Precious metals could quickly regain a bid if the deal is viewed as insufficient to maintain the AAA credit rating. Oil would strengthen on higher economic growth prospects and bank shares would be relieved by the lower overall levels of market risk.
2. Debt ceiling not extended immediately
If the politicians remain gridlocked and do not extend the ceiling and continue to waffle on the issue for the next couple of months, we think the economy could slip into recession as growth prospects would be in sharp decline. The stock market could fall 15-20% and the U.S. dollar could weaken significantly against gold, the Japanese Yen, and the Swiss Franc. Credit spreads could rise and ironically, bond yields could fall as the economy stumbles. Defensive sectors like pharmaceuticals, healthcare, and food retail would likely fair the best in a much weaker stock market environment.
3. U.S. debt default
Our worst case scenario. A $29 billion coupon payment is due August 15th and if the government
misses this payment there are several major ramifications. The money market system would seize as lending amongst banks would cease very similar to the 2008 crisis. Unlike in 2008, the only entity able to bail us out now would be the Federal Reserve since the U.S. government would be unable to ‘spend’ our way back to prosperity. The Fed would quickly introduce a QE3 and the U.S. dollar would tank on that news. Precious metals would soar.
Stock markets could fall 25-30% and equity investors should focus on large cap, high free cash flow generating firms that have better credit ratings than the U.S. government. If the U.S. defaults it would be followed swiftly by Portugal, Ireland, and Greece likely pushing the global economy into a recessionary tailspin. Rough estimates suggest U.S. GDP could fall as much as 5%.
It is clear leaders from both parties in Washington are playing a dangerous political game with the nation’s AAA credit rating. The deadline of August 2nd is less than a week away and despite Standard & Poor’s warnings of a possible debt downgrade leaders are still only offering broad outlines with few specifics. These political theatrics are failing to build confidence in the minds of market participants.
Although volatility has picked up, the financial markets have thus far remained relatively calm in the face of ever-increasing uncertainty over the next few days. Market sentiment can change quickly, especially when credit ratings are involved, but the bond market is not calling for the end of the world as we know it. The markets are in relatively good shape given the problems of the day. Markets that can digest bad news tend to be markets that surprise on the upside.
Until the evidence begins to shift (and it may), the bull market in equities should continue but holding some gold and silver as insurance hedges against some shockingly poor leadership from the elected officials in America.