Smartwealth 2 hours ago 15 Oct 2013 US Debt Ceiling: What does it all mean? Sometime towards the end of this week the US is likely to hit the “debt ceiling” (again) unless there is a political back down on one side or the other first. While it remains uncertain if a political solution can be found before that time, we believe that a resolution will be achieved either before, or very shortly after, in response to mounting pressure from financial markets and the investing public. We look at three scenarios of what we consider may happen but before we do, it is worth exploring first of all what the “ceiling” is all about and how it impacts. Also it is important to understand why this is different to the Global Financial Crisis but in the extreme could end up with a similar outcome. What is a Debt Ceiling? The US has a legislative limit, in dollars, as to how much debt can be issued by the Government. Over time as the economy grows this limit needs to be adjusted upwards. This has happened for decades with occasional flash points being reached. It provides an opportunity for opponents of “big government”, or in this case a government initiative like “Obamacare” that will add to the size of the government sector, taxes and so forth, to literally hold the government and country to ransom. This is mainly to make a political point and reverse a situation or initiative. Thus this debate is almost wholly political in nature and therefore something where the outcome and the timing are not easily predictable. More often than not the negotiations are usually taken to the brink. Given markets are averse to uncertainty this usually causes them to react to the possibility of what might happen. Will the US ‘default’? The “debt ceiling” that may be hit this week will prevent the US government from issuing any more debt in the forms of bonds and Treasury bills, however it does not mean that they have run out of money and cannot pay bills from that day. It also does not mean that they cannot roll over maturing securities but investors may not want to buy them if the previous interest payment has not been received. In terms of the US ‘defaulting’ on debt by not meeting interest payments this may not occur until 15 November when US$31 billion of interest payments are due. There is a considerably smaller payment on 31 October of US$6 billion, which the US government may be able to repay with cash on hand. There are two possible scenarios that the US may follow to deal with the inability to raise the debt ceiling: 1. Pay some bills, but not others; and 2. Make all of each day’s payments together once enough cash is available. While scenario one would in theory push out the date on which the US government is unable to meet its interest payments, it is not clear that it is feasible for the US Treasury’s systems to prioritise US$100 million monthly payments in such a way. The inability to borrow would see an effective tightening of fiscal policy in the vicinity of 4% of GDP (the current level of budget deficit), a clear and very material negative for growth. However, it is important to realise that this is a very different situation to, say, Greece, which defaulted in absolute terms and capital was destroyed, or Lehman Brothers where capital was also destroyed. Any “default” in this case will be due to not paying the bills when they come due, but the expectation is that they will be made good (although probably with no interest compensation for the period of delay) sometime shortly afterwards. Also any default will not automatically happen when a payment is missed – generally there is a short grace period before that is deemed to happen. So there is scope for this brinkmanship to carry on right through to early November without a catastrophic failure of the system, or an absolute need to remedy it. This would be very disruptive to markets as the longer this goes on the more nervous they will become. What does this mean for markets? The market impact from the failure to extend the debt ceiling would be negative for risk assets as well as some classes of bonds. Equities, credit (particularly lower rated) and emerging markets (debt and equity) would all weaken. Core non-US government bond markets would rally on rising risk aversion, although peripheral markets, such as in Europe, may weaken. It is possible that US Treasuries may still be well supported if markets continue to believe that there will not be be a true default by the US government, only just the current disruption. Nevertheless, high grade credit may perform well as it is sought out as an alternative source of collateral. The Australian and New Zealand dollars are expected to weaken on concerns over global growth, with the greatest corresponding strength in the Yen, Pound and Swiss Franc. We see a very low probability of an extended failure of resolution. The three scenarios we consider might eventuate are: 1. Resolution before 17 October Equities are expected to rally modestly on this outcome, consistent with positive fundamentals and expectations that any continuing uncertainty over US fiscal policy will keep Quantitative Easing in place. Bonds are expected to remain supported. 2. Debt ceiling hit but with a quick resolution Even though passing the 17 October deadline may not bring an immediate default, markets are likely to react negatively to its likelihood. This and the possibility of increasingly negative polls for the Republicans would be expected to bring a rapid resolution. 3. Debt ceiling hit with no quick resolution with accompanying fiscal impact and credit event While this scenario is highly unlikely, if this happens, the US economy would be pushed back into recession with a sustained 4% of GDP fiscal tightening as the budget needs to return to balance immediately. This protracted situation would raise concerns over the operation of financial markets (especially if counterparty collateral contracts are literally interpreted). A three day failure to pay raises the likelihood of a Credit Default Swap (CDS) credit event. A default status for the US government also raises questions about the use of US treasuries as collateral and the operation of “repo” (security repurchase) markets. Market liquidity is likely to be a causality of this scenario. This in itself will be a clear negative for the US and global economies and, probably, banking systems. We regard the market liquidity aspect as potentially most concerning, particularly in light of how the GFC played out. However there is a fundamental difference between the debt ceiling and GFC episodes. The freezing of markets following the collapse of Lehman Brothers followed 12 or more months of deteriorating credit quality in housing related financial instruments and as such had no real backstop. However, in the case of the debt ceiling even if there is a temporary delay in payment we don’t believe there is a true expectation that the US can’t or won’t pay (i.e. this is a “technical issue”.) A resolution of the impasse would remove the short-term uncertainties, which was not the case for the US subprime issue as poor fundamentals dictated that markets had a real and very painful course to run. What does this mean for investments? The risk we face is a binary event, with the small probability event (i.e. scenario 3) having a large potential impact, which by its nature is a difficult event to set a strategy for. What investors can do is to prepare for this is by maintaining a well-diversified portfolio with a focus on quality assets. In our diversified funds we are maintaining our strategy of a mild overweight to growth assets which is consistent with the outcome being scenario 1 or 2. While it is uncertain, if this situation became materially worse we expect the Australian dollar to weaken against most currencies as the impact of a perceived significant risk to global growth will outweigh the perception as a safe haven. In this instance the overweight foreign currency exposure from the portfolio’s international equities holdings will help to buffer the weakness seen in equity markets, providing a degree of natural hedge if things take a turn for the worse. In aggregate, our portfolio holdings in equities and bonds, have a bias to higher quality, more defensive securities. Only if the situation became extreme and a major financial institution failed due to conditions in derivatives market would we need to reconsider our investment stance. Even then, as we saw in the GFC, we expect that there would be massive central bank intervention to attempt to minimise the impact. Also if that happened we expect that there would be time to take action, as there was following the Lehman collapse in September 2008. The equity market did not bottom in that situation until six months later in March 2009. So for now we are carefully watching the situation and not being panicked into trying to ‘make a bet’ on what is a ‘binary’ outcome. A temporary disruption may instead result in a good buying opportunity for growth assets depending on how it all plays out. Stewart Brentnall Chief Investment Officer Mark Rider Head of Investment Strategy and Asset Allocation Disclaimer: This information is current as at 15 October 2013 but is subject to change. This information is issued by Australia and New Zealand Banking Group Limited (ANZ) ABN 11 005 357 AFSL 234527. The information is intended for the use of financial advisers only and is of a general nature and does not take into account a potential investor’s personal needs and financial circumstances. ANZ and its related entities make no representation as to the accuracy or completeness of the information. It should not be construed as investment or financial product advice, and should not be relied upon as a substitute for professional advice. To the extent permitted by law, ANZ and its related entities do not accept any responsibility and liability from the use of this information. Past performance is not indicative of future performance. Justin McMillan is an Authorised Representative of RI Advice Group Pty Limited (ABN 23 001 774 125), Australian Financial Services Licence 238429. This editorial does not consider your personal circumstances and is general advice only. You should not act on the information provided without first obtaining professional financial advice specific to your circumstances. The taxation information contained in this editorial is provided as a guide only and should not be relied upon. You should seek independent tax advice from a qualified tax adviser.
Posted on: Wed, 16 Oct 2013 02:53:58 +0000
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