The three things I would tell my clients this week:
A US debt default is a real, non-zero probability. Partisanship appears to be at an all-time high, skewing legislative priorities away from cooperation and towards acrimony.
In 2011, when a debt default was threatened, US stocks fell by 16%. In a 2013 study, the Fed simulated the effects of a stoppage of payments. It calculated a 30% drop in equities, a 10% drop in the Dollar and a roughly 6%-10% in bonds. GDP growth would be cut by about 1.5% in the same year and unemployment would rise also by about 1.3% a year after.
Our base case scenario is that the event itself won’t happen. There are powerful incentives for a last-minute deal. And if it does, central banks will probably deploy their balance sheets once again to help global stocks and bonds. However, Over the longer term, a wanton US default would probably force asset managers to reconsider the natural primacy of US assets in their portfolios.
A US debt default could happen. What then?
The inevitable US debt ceiling drama is upon us. With the earnings season now mostly behind us, the eyes of investors will inevitably turn towards Washington DC. Investor surveys suggest that this is now the larger risk in financial markets.
Here’s what is at stake. In the next couple of months, the world’s biggest economy will either decide to increase its debt or default on its payments (internally and/or externally).
It is, of course, easy to dismiss the upcoming battle as the usual political posturing which will inevitably end with some sort of compromise deal. And, despite the acrimonious build-up, it is still our base case scenario. However, the lesson from Covid-19 is that we should be very careful as to what we dismiss as “one of those things”. Tail (low probability) events exist. Is this instance close to become a tail event? We believe this time, the risks are more pronounced and that we could, at least, see a replay of the 2011 Debt Ceiling Crisis.
2011
What happened in 2011? The last big debt ceiling crisis. Twelve years ago, Republicans gained back control of the House of Representatives for the first time after Barrack Obama’s election. Reeling from the unilateral passing of the Affordable Care Act (“Obamacare”), the Republican caucus demanded spending cuts in healthcare as a way to defang the new law, in exchange for increasing the debt ceiling. The stand-off sparked a crisis in equity and bond markets, at a time when investors were still reeling from the Global Financial Crisis and were fearful of the oncoming Euro Crisis.
The two parties struck a complex and constrictive twelfth-hour deal to curtail expenditure. Ever since the debt ceiling negotiation has become a contentious point. While we never really saw a repeat of 2011, parties now routinely threaten to cause a default in US payments in order to obtain political leverage. PIMCO has calculated that whenever there are debt ceiling negotiations, stocks fall 6.5% in the prior month[1].
Looking at the issue from a bird’s eye view, there are plenty of reasons to believe that a replay of 2011 is likely. It is also not unfathomable that, unlike 2011, a deal might not be reached in time. In 2011, a routine process turned into a fight. Now the question is whether the fight, the new status quo, will evolve into its next step, an all-out war. And a US default.
Why do we think this time might be the same as 2011, or even worse?
Washington and Wall Street don’t always communicate
For one, Washington and Wall Street have a known disconnect. Where Wall Street worries about money, elected leaders worry about “optics”. In 2008, Republican Treasury Secretary Hank Paulson was getting ready to pass his emergency TARP bill on the floor (Troubled Asset Relief Program). The bill was paramount for financial stability, as the capitalist structure was fast collapsing. This was in September 2008, six weeks before the general election. Before the vote was put to the Senate, John McCain, the Republican Presidential candidate, broke the campaign trail and showed up in Washington with the explicit intent of scuttling it. He was worried that the government spending $800 bn so close to the election would create negative optics. Paulson, a seasoned Goldman Sachs executive, was less worried about the optics and more worried about the ATMs running dry. He rushed to Congress and reportedly kneeled in front of House Speaker Nancy Pelosi asking for help from the Democratic caucus. The bill passed with the help of the opposition and became the first backstop against an unfolding financial crisis of biblical proportions.O
Partisanship is really high
This brings us to the second point. The effect of partisanship. Wall Street thinks that elected leaders would be seen as ubiquitously bad if their failure to reach a consensus caused the world’s biggest economy to default. This shout be enough to stave off a default. But this may not necessarily be the case. According to a recent poll by the Washington Post, 50% of Republicans and 60% of Democrats consider party affiliation as the single most important reason in making friends[2]. 75% of all voters consider voters who vote for the other party, as “bullies” and “untruthful”. Elected representatives, especially when majorities are razor-thin, may take no chances, and avoid the higher road, fearful that they might upset their base. 60% of voters already think the government is corrupt anyway. Only 20% of people trust in government[3].
Humans are creatures of incentives. If good governance is rewarded by voters, then angels will run the government. If elected representatives are elevated with a singular platform to be an extension of voter frustrations, then the best case scenario is mulishness over important issues. The worst is institutional sabotage, in hopes that the “other side” will get blamed. is so pronounced that the other side is viewed as “the enemy”. And when we reach that point, well, all is fair in love and war. Partisanship is connected with the rise of social media. A study by the Brookings Institution showed that social media have augmented the political divide[4]. And because they were not nearly as strong ten years ago, this means one thing: that this is not 2011. It’s possibly worse.
What would be the impact?
If that scenario materialises, a stoppage of payments to internal and/or external lenders, we believe that there could be a severe economic impact, as well as significant financial market stress. In a 2013 study[5], the Fed simulated the effects of a stoppage of payments. It calculated a 30% drop in equities, a 10% drop in the Dollar and much higher bond yields. Given that the amount of algorithmic trading has grown exponentially in the past decade, the effects could be bigger. International markets would likely follow suit. GDP growth would be cut by about 1.5% in the same year and unemployment would rise also by about 1.3% a year after.
Companies, that rely on Short-Term Treasury Bills (the world’s risk-free asset) for a cash equivalent, would default on their obligations to one another. Coupled with the rise of shadow banking in the last few years, the effect would be significant. Social security payments of $100bn per month would stop. Central banks would have to perform damage control, probably by re-extending their balance sheet and possibly even performing a reversal of recent rate hikes. The effect on the Dollar could also be pronounced. While the world is in no realistic danger of de-dollarisation, a wanton stoppage of payments could make international bondholders think twice before lending money to Washington if they felt that they would be held hostage every two years.
But this analysis assumes that central banks will not intervene.
Are there backstops?
Can the US government do something about it? Janet Yellen, the incumbent Treasury Secretary, has said that she doesn’t even want to consider the alternatives. There are some legal ways around the debt ceiling, but they could end up causing more harm than good.
Some advocate for the President invoking the 14th amendment, which states that the “validity of US debt shall not be questioned”. Legally it’s a logical jump, as it’s not the validity of the debt questioned, rather its size. At any rate, the President can’t do it without clearing it with the courts, and a conservative Supreme Court would, logically, dismiss that route as a power grab. The government could also “mint” a “$1tn” coin, to pay off its debt. This is a high-risk legalistic concept, which, implemented, would allow the government to pay off its debt without the authorisation of Congress or the Supreme Court. But it would also allow the President to ignore Congress altogether, and fund projects she or he would favour in the future. In essence, it would render the legislative part of government in the world’s oldest modern democracy, decorative.
What does it mean for investors?
When all is said and done, we are talking about an unprecedented, systemic event that will affect all portfolios. Not a “Black Swan”, in the sense that we already assign a non-zero probability to the event before it happens.
Having said that, Central Banks have the tools to mitigate the damage. A US debt default is probably the type of event that would tip the scales against inflation fighting – at least over the shorter term- and in favour of financial stability. In plain English, it means a high probability that the Fed would take emergency measures to quell market fears.
The worst-case scenario for investors is the combination of two low-probability events: a) that what has never happened before, will happen (a wanton default) and b) that central banks and the government will idly sit by and watch.
Our base case scenario is that the event itself won’t happen. There are powerful incentives for a last-minute deal. And if it does, central banks will deploy their balance sheets once again to help global stocks and bonds. It won’t be about credit lines, like in the case of peripheral banks, but direct buying of US securities across the yield curve- a practice known as Quantitative Easing. The US Treasury will also try to come up with ways to fix the problem, at least over the shorter term. So the market crash would probably be short-lived.
Over the shorter term, and given our general aversion to risk at this period, we feel that our portfolios are well-positioned to weather the storm.
Over the longer term, however, a wanton US default would probably force asset managers to reconsider the natural primacy of US assets in their portfolios. Investors, who build their portfolios on the bedrock of the US Treasury Bond, will be alarmed if Washington's malfunctions challenge the world’s risk-free asset and the very fundamentals of investment. 59% of the world’s reserves are in US Dollars. Asian consumers will still want dollars, of course, every time their currency is in danger of devaluation. But a default would challenge dollar supremacy globally and investors would ask for higher risk premiums to invest in it. Economists also see great harm to the global economy. Diplomats and historians could mark such an occurrence as the beginning of the end of the American Hegemony.