Political Chicken With The Debt Ceiling
The current political debate over whether the debt ceiling should be raised has been the topic of much conversation by the Investment Policy Committee. Both sides of the political aisle have drawn ideological lines in the sand making compromise difficult. This game of political chicken, where both sides are hoping to force the other to swerve off the road, has created a media frenzy. However to date, it appears the markets believe that the political posturing will likely not prevent a final settlement prior to the August 2nd deadline. However, it is prudent to consider the possible financial market ramifications that could result if the political standoff is not resolved.
Three past events provide a starting point for considering the possible impact of a US default: 1) the Latin American Debt crisis in the early 1980s, 2) the US government shutdowns during the fall of 1995 and 3) the Russian Bond default of 1998.
Latin America Debt Crisis
During the 1960s and 1970s the world was eager to lend to Latin America due to its fast economic growth. However, in the early 1980s, an increasing interest rate environment coupled with a global slowdown and recession in the US made it difficult for these countries to meet their obligations. In August 1982, Mexico confirmed the fears of the rest of the world and suspended payments on its debt. As shown in the chart below, the US equity market experienced a short negative shock but recovered quickly. Yields on US Treasury debt fell quickly during the crisis as demand for Treasuries increased.
US Government Shutdowns
A fight between the Republicans in Congress and the Clinton Administration over the budget resulted in two short term, temporary government shutdowns in 1995. During the shutdowns, government services were delayed, national parks closed, and some government employees were furloughed. Prior to the shutdown, the country had been propelled forward by strong confidence in the technology sector’s ability to promote fast economic growth. As shown by the chart below, the financial markets barely noticed the shutdowns. One reason for the optimism was the decline in the budget deficits during the mid-1990s, which eliminated fears of future debt problems.
Russian Bond Default
The Russian default of 1998 sent large shockwaves through the global financial architecture. The default was brought on by an overvalued ruble and a decrease in world commodity prices. The crisis also caused the demise of the US investment fund, Long Term Capital Management, and changed the way financial markets view risk. Treasury yields were declining prior to the crisis, which was accelerated as a flight to quality increased demand for safe US treasuries. The initial default also triggered a sharp decline in US equity prices. After a period of increased volatility, the equity market started a steep recovery and by December had reached the previous highs for the year.
All three cases demonstrate an increase in volatility in both equity returns and treasury yields. Although the three situations differ, there are elements of each that can give insight into the current debt ceiling situation. In all cases, trying to strategically time selling and correctly estimating the bottom of the equity market was and continues to be very difficult. Many investors sold after the original decline as the situation appeared to worsen. Then, bitten by the memory of the earlier losses, waited too long to catch the quick rebound. The trend line in each graph further illustrates the case for patience. In each case the crisis caused a short-term disruption to a strong bull market. The simple total return for the S&P 500 for the year plotted on each graph drives this point home: Latin America crisis +34.4%, US government shutdown +16.7%, Russian default +25.4%. Investors who rode out the volatility were rewarded for staying the course. While there is no guarantee that a similar return would happen today, it is compelling evidence that fending off the fear that comes in the height of a crisis can pay rewards.
When considering the possible consequences of Congress deciding not to increase the debt ceiling, it is important to compare today’s global economic environment to that of the past. In both default scenarios above, the country defaulting ran into a legitimate lack of ability to pay its debt. If the US defaults by not increasing the debt ceiling, it is not lacking ability to pay; instead it is signaling a lack of willingness to pay its debts. Given the special role of the US Treasury market as the world’s safe haven, a lack of willingness to pay will not be received favorably by the global financial markets. The debt picture is also much different than it was during the 1995 government shutdown. The total amount of debt held by the public (not including US intra-government holdings such as the Social Security Trust Fund) is equal to over 65% of US GDP today and increasing, compared to 48% of GDP and decreasing in 1995. Additionally, the portion of that debt held by foreign interests has increased from 23% in 1995 to 47% today. The combination of these factors creates the potential for a US default to trigger a much larger global financial crisis than the past defaults of Mexico or Russia.
After careful consideration of our research and review of the case studies in this article, the Investment Policy Committee strongly recommends staying fully invested. After reviewing our models, the positive and negative impacts that could result from a US debt default, and the probability of such an event, we came to the conclusion that moving out of the markets at this time could create more portfolio risk than the debt event itself. The volatility the markets may experience over the next couple weeks could be short lived; we are monitoring this situation and will communicate to clients any further action needed. If you are exceptionally concerned, we have put together a couple hedging strategies for you to consider. If you have questions about your investments or this article, please contact our office.
-River Glen Investment Policy Committee