The debt ceiling crisis is disconcerting for investors. Raising the debt ceiling in conjunction with a credible deficit reduction program would have removed the issue from the investment landscape and benefited our nation’s economy. We have long believed that a credible plan would need to address both revenue increases and reductions in expenditures. Along these lines, a plan that would include $4 of spending cuts for every $1 dollar of increased revenue would have been economically realistic.
A week ago elected officials appeared far closer to such an agreement than we would ever have expected. We had always been skeptical of the potential for a “grand bargain” with a presidential election looming in 2012. However, we expect the debt ceiling to be raised, averting default, but that structural deficits will not be addressed. As such, US government debt is likely to be downgraded to AA+. This would have a relatively modest immediate impact on the market and major debt reduction would have to wait until after the 2012 election. We believe this to be the most likely scenario.
If an agreement is not reached and the US technically defaults, the market reaction would be fast and brutal. While market performance would be very volatile and overall outcomes hard to predict, we are confident that a plunge in global markets would result in swift action by Congress. Again, we believe that this would likely result in a deal that would raise the debt ceiling limit while failing to address the long-term reforms rather than a “grand bargain.” While a rally would ensue, the situation would be highly unpredictable and global equity markets would likely remain below pre-default levels. However, other asset classes would likely hold up better than equities. Commodities would likely decline along with equities. However, a default is apt to result in a significant decline in the US dollar, in which global commodities are priced. As such, commodity prices would likely decline less than equities. Oddly enough, we would expect domestic investment grade fixed income to hold up reasonably well, especially the corporate and MBS markets. Emerging markets debt would likely decline, but far less than global equities. They may even draw bids from investors attracted to emerging sovereign balance sheets and strengthening currencies.
While the situation remains fluid and unpredictable, given our base case that a deal gets done, if not sooner, then later, we have decided not to alter portfolios. As noted above, just a week ago it appeared that the Administration and Congress would agree on a deal that actually would have significantly addressed our structural deficits. By moving to cash in such situations one creates binary outcomes. We prefer to adjust portfolios when we can move the odds of success into our clients’ favor. Importantly, unlike the collapse of the credit bubble, this is not a true financial crisis, but rather a political one. What has been obscured by political rancor is the fact that the United States has the ability to pay its bills and secure debt on very favorable terms. Simply put, the nation is not in an economic straightjacket.