The President and the U.S. Congress are working to reach a deal to raise the U.S. debt limit by August 2nd. The government budget is made up of spending and revenues, and if revenues fall short of spending we have a deficit. The national debt is the total of past deficits. Normally, the debt ceiling is raised as a matter of course. During the past administration congress voted for debt ceiling increases totaling more than $5.3 trillion. Today, there is a political battle; that’s politics.
Let’s assume that the U.S. did default on its debt; what then? (But we strongly believe that an agreement will be reached before this outcome). A worst-case scenario would have U.S. Treasury yields rising (the U.S. would have to pay more to borrow) significantly, bringing interest rates up alongside, representing a tightening of financial conditions in less-than-perfect economic times. The U.S. dollar would likely drop, as would stocks.
But there is also a lesser held view that markets may not move as dramatically as many are assuming. In fact, it’s supported by the so-far benign moves by both stocks and Treasury bonds as we’ve approached the deadline. The deadline is approaching but there is no sense of panic. Demand for U.S. Treasury securities has remained strong throughout the debt-ceiling debate and stocks have been volatile, but not excessively weak. This suggests investors don’t believe there will be a default and/or that Treasury prices are already reflecting the global concern. A default (particularly if it was short-lived) could cause the stock market to fall to the lower end of the trading range it’s been in for more than a year, but may also provide some support for stocks if it triggers more meaningful negotiations and ultimately a bigger deal on debt/deficit reduction.
What does history tell us about defaults? We don’t really have much history to go on to gauge market reaction except for other countries that have lost AAA ratings. S&P downgraded several European countries (Belgium, Ireland, Italy, Portugal and Spain) from AAA in May 1998. Then, a week later, 10-year bond yields for those countries were only slightly higher; a month later they were actually slightly lower; and a year later they were nearly 1% lower. Japan lost its AAA rating in February 2001. A week later its 10-year bond yield was flat; more than 0.3% lower a month later and only slightly higher after a year. The most recent US government shutdown was from December 13, 1995 to January 6, 1996. The Dow Jones Industrial Average actually rose about 2% during that period.
What to do? We’ve heard a lot of questions about what investors should do in their portfolios to account for the risk of a default. We continue to preach the benefits of diversification among and within asset classes, both domestic and international. Even if you did put all your cash under your mattress, you would have problems if inflation accelerated, not to mention the lost opportunity cost in the event of a substantial relief rally in stocks and bonds. Finally, another reason for hope beyond the debt-ceiling debate comes from corporate earnings. We’re still early in the reporting season for second-quarter earnings, but so far about 75% of companies have beaten expectations, which is historically high. The positive reports have been across a broad range of industries and sectors and earnings are on track to surpass their 2007 peak.
I know, it’s frustrating to see your account go down. We can make any changes you want but that would be a mistake to react. Our best advice is to stay put, collect the dividends and interest coupon you earn on your portfolio and ride the psychology driven markets up and down. In the end, the companies’ ability to grow revenue is what matters and eventually , market valuation will pick up again.