1. What is going to happen in the Debt Drama?
Well, the answer is “it depends.” Three broad outcomes (the Three D’s) are possible: Deal, Downgrade, and/or Default. The latter term (“default”) is the most charged, sweeping, and scary – as such, politicians and the media have been quite cavalier and unspecific with its use. Let’s handicap the possibilities:
The competing Republican and Democratic debt ceiling-extension deal proposals are actually very similar in that both: a) Do not even begin to address the true magnitude of the problem; and, b) Use fuzzy math to achieve their supposed gains. The Democratic plan claims to save $2.2 trillion, but the gains are achieved over ten years – and half of which are due to projected savings on withdrawals from Afghanistan and Iraq. Meanwhile, the current Republican plan claims to save $850 billion over ten years while raising the debt ceiling by $900 billion this year. This is largely political showmanship rather than substantive change. However, BSW continues to believe that some type of compromise legislation sufficient to raise the debt ceiling will ultimately pass in time to avert a true default, though it will: a) Not make meaningful changes; and b) Merely kick the debt can (shortly) down the road once again.
Downgrade: Likely, but not certain.
As discussed above, it is unlikely that the Congress will pass meaningful spending cuts. As such, even following an 11th hour compromise, the debt situation will remain unsustainable and possibly prompt a downgrade of US debt from AAA. Should this actually occur, the impact may be minimal, as it seems the entire credit spectrum would simply shift downward. The US Dollar remains the world’s only viable reserve currency, so in many ways, AA may become the “new” AAA. The big risk with a downgrade is that interest rates may rise, potentially torpedoing the still-fragile housing market and, ultimately, raising US borrowing costs. That outcome, however, is far from certain, as any economic contraction driven by a US downgrade may create yet another “flight to safety,” which has traditionally meant a flight to US Treasuries. As an example, Japan lost its AAA status about 10 years ago and yields on 10-year Japanese government bonds have actually fallen and now stand at just 1.0%.
Default: Unlikely, but “it depends.”
Default is a very loaded term. As such, it is very, very important to define the scenarios meant by “default.”
Could the US be late on a Social Security payment? Sure. Furlough government workers? Yep. Fail to pay government contractors? You betcha. Will any of these developments necessarily tank financial markets? No. (Incidentally, Treasury Secretary Geitner would likely use the opportunity to send Social Security recipients a friendly letter saying, “I really wanted to send you your check this month, but the evil Republicans wouldn’t let me.” Ah, the joys of scorched earth politics . . . )
Will the US be late on a Treasury Bond Payment? Maybe, but very unlikely.
Will the US fail to redeem maturing Treasury bonds? Unthinkable – to the extent that this possibility has negligible probability. This would throw the whole global financial system into a tailspin. But, again, it is highly, highly unlikely.
2. What aspects of my portfolio are most vulnerable to a Downgrade or a Default?
Equity market positions, most likely. From our perspective, financial markets have already largely priced in a downgrade of US Debt. And, as hard as it is to believe, financial markets are, by and large, more rational than politicians or the media. A downgrade will likely be, in hindsight, a minor issue.
Although we believe that a true default (failure to pay Treasury bond interest or maturities) is very unlikely, if it occurred financial markets would certainly panic and that panic would affect equity markets most quickly. US Treasuries are THE benchmark “risk free” asset against which all other investment assets are compared, so a wholesale, blatant default could upset the very fabric of the global financial system. That said, we focus on things that are probable, not just possible.
3. What should we DO?!?!?!?!?
We are not in a panic to do something NOW because WE ALREADY TOOK DEFENSIVE ACTION IN MID-JUNE.
Within our portfolios, we always want to be proactive not reactive. We knew that the US debt ceiling issue was coming. We knew Congress would stalemate. We knew the markets would spook. Anyone who is just now considering the situation or proposing action is quite tardy in their diligence!
Here are the PROACTIVE and DEFENSIVE actions we ALREADY TOOK in mid-June:
1. Took profits on our Australia, EAFE, and Software Sector Positions – ALL of these positions are now below our sale prices.
2. Raised a 7% opportunistic cash position – funds we plan to deploy if and when the markets retract further on the impending Debt Ceiling deadline.
3. Continued to hold our defensive positions in Gold, Managed Futures, and defensive sectors like Healthcare and Consumer Staples.
We took profits in mid-June when the Debt Ceiling Drama had yet to overtake Greece as the “crisis of the week.” Likewise, we look forward to investing our cash reserve when it appears the sky is falling. We aspire to be “ants,” not “grasshoppers,” or, as Warren Buffet is often quoted, we want to be fearful when others are greedy and greedy when others are fearful.
If you would like to discuss this outlook or your portfolio in greater detail, please don’t hesitate to contact BSW. As always, we are happy to help.
-David Wolf, Chief Investment Officer