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发表于 2011-10-10 00:10
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I put out a white paper today on my take on things... I figured I'd post it here too, since I've been talking about it so much.
Strategy Implications of the US Debt Ceiling Impasse
Scenarios for a financial Cuban Missile Crisis
The current debt-ceiling fight in Washington has the financial punditry atwitter with speculation on whether the US will default on its Treasury obligations come 2 August 2011. Current media coverage seems to focus mostly on whether or not a default will happen, with vague references to the fact that the consequences will be “big.” It is important to remember that good investment strategy is not so much about predicting the future as it is about knowing the range of possible outcomes and having ready responses to them while others are caught deciding what to do. If the US debt ceiling impasse is not resolved by the August 2 deadline, what are the likely effects, and what are the appropriate strategies?
Summary
A more detailed analysis appears below, but the key takeaway is that virtually all scenarios are negative for US equities, with differences in degree only. The scenarios are mostly negative for commodities as well, with the exception of precious metals. A last-minute agreement will be helpful to fixed income markets in the short term but will ultimately be bearish as investors question whether debt ceiling brinksmanship has become a permanent part of the political landscape. In currencies, the scenarios are largely negative for the US Dollar, but in the disaster scenarios, many currencies will not hedge as much protection as one might think because some economies are so closely intertwined with the US that a default and subsequent economic collapse may take down other economies as well.
A silver lining is that required returns are likely to be attractive following a crisis, whereas there is relatively little upside to be lost by setting aside cash, compared to the downside risks of being overly exposed to all risky assets. The market does not appear to have “internalized” or “discounted” these possibilities, because there is not nearly the degree of panic that would be appropriate. And large institutions simply may not be able to adapt quickly enough to avoid being hit.
There are three major effects to consider in each scenario: a) the immediate effect on asset markets as investors panic, feel relief, and/or reallocate, b) the short-term effect of increased Treasury yields on all assets as investors slowly digest that they are more risky, and c) the longer term effects of a budget agreement and/or higher required rates of return on the macroeconomy and earnings.
Scenarios
There are basically three possible scenarios for the situation to play out. Even an 11th hour agreement is likely to have long-term impacts on US creditworthiness and the yields that lenders will demand for taking on US debt, with follow-on effects. The scenarios are:
? A last minute budget/debt agreement saving the day
? No agreement, but no default
? No agreement, and the US defaults on some obligations
Scenario 1: a last minute agreement “saves the day”
As I write, a last minute agreement is still the most likely scenario, but market participants seem to be acting as if the probability is in the 85-90% range, simply because “it’s unthinkable otherwise.” My sense is that few politicians truly understand how devastating a real default will be, because no one seems to be sufficiently panicked. As a result, the incentives for politicians to “stand their ground” instead of “reaching a compromise before it’s too late” are strongly loaded against compromise. My admittedly subjective guess is that the likelihood of reaching an agreement is probably much closer to 50-50 than most market participants currently seem willing to admit. Since we cannot observe probabilities for things like this – only outcomes – we will never actually know the probability, but we still need to make a guess in order to determine a course of action.
The full effect of a last-minute agreement allowing debt ceiling to rise depends, obviously, on what is actually inside the agreement. This makes the current situation especially challenging because 1) an 11th hour agreement remains the most likely scenario, and 2) what an agreement would entail is highly sensitive to factors that are largely unknown to anyone not actually present in the bargaining rooms (and perhaps unknown even to those inside them).
It is pretty clear that an agreement would most likely involve some combination of spending cuts and tax increases, even if the exact balance of the two is unpredictable. The game theory of the situation really seems favors the Republican agenda, simply because an economic contraction based on an agreement or a default will be easier to blame on the administration during the next election. Republicans (and especially the Tea Party) thus have little to lose by maintaining a hard line, even to the point of a US default.
It is true that Republicans did take the blame for the 1997 shutdown, but there was little electoral consequence from it – Congress did not change hands in 1998 and no Presidential election took place. Furthermore, the shutdown took place in a growing economy, so few people were genuinely affected by it. When the economy is looking down, the incumbent power usually takes the heat, right or wrong. As a result, the Republicans have the upper hand, and any agreement is likely to focus on spending cuts over revenue increases.
Either way, the effects of an agreement will be contractionary for the economy and negative for stocks and investments with any kind of market risk, although there may be a brief stock pop to the upside as a result of immediate uncertainties about debt payments being taken off the table. Cutting spending in any way will reduce GDP by the amount times a circulation multiplier, and any tax increases will also crimp economic growth.
Depending on the degree of pressure alleviated from the Treasury, a last minute agreement might prove either positive or negative for Treasury securities (and fixed income generally). If stocks are badly hit, and an agreement is in place, many investors will reduce their risk and most likely move assets to cash and the front end of the Treasury curve, steepening it at least a bit.
Lower short term rates will reduce futures prices for commodities marginally, but commodity spot prices are more likely to be influenced by broad economic expectations (lower) and stock performance (also lower). Thus, even a last-minute agreement is likely to be moderately negative for commodities.
Even with an agreement in place, investors now must face the very real likelihood that debt-ceiling brinksmanship is now a permanent feature of the US political landscape. Even if the US Government dodges the bullet this time, there is nothing to indicate that this kind of political fight will not happen over and over again the next time the ceiling is hit. Future increments in the ceiling may actually become smaller and smaller over time precisely to increase the leverage that minority parties have. It is, in effect, the fiscal equivalent of the filibuster, which itself has increased dramatically in our polarized politics.
This means that – regardless of actual default – the political risk of holding US debt has risen materially, and rational investors have little choice but to demand higher real returns for assuming it. Whether this change is sufficient to motivate ratings agencies to downgrade US debt from its AAA rating remains to be seen, but individual investors and institutions will start to require more yield as compensation. This will send fixed income portfolios down, and – more importantly – increase the required return (or discount rate) applied to virtually ALL other risky assets.
An important issue that many analysts appear to miss is how sensitive market valuations are to the unusually low interest rates. Stocks may be considered mildly overvalued or even fairly valued, given the current sub- 1% yields on short term Treasury securities, but if Treasury yields jump up due to political risk, fair valuation multiples can drop like a rock into a well. It is this dynamic which is particularly dangerous today, and few analysts seem to bring it up.
Scenario 2: no increase in the ceiling, but no default
Even with no increase in the debt ceiling, the US can continue to roll over expiring debt and remain under the total debt limit. However, programs cannot expand or even receive (currently small) inflation adjustments without increasing the debt load. Furthermore, the Treasury will not be able to capitalize interest payments, so any payments made would have to be financed by squeezing money out of programs with existing budgets. An alternative to outright default is thus to shut down portions of government spending. The failure of Congress to raise the debt ceiling does not automatically mean that the US stops making principal and interest payments on its obligations, as long as it can cut spending from elsewhere. Indeed, this may be the Tea Party’s unspoken goal – to force government into to stop spending immediately.
But doing so would not be without consequences. It would almost certainly result in legal actions by current recipients of government funding: government contractors not being paid, entitlement recipients suing for payments they are legally entitled to, etc., and the accumulation legal fees would quickly become an additional drag on public finances and capacity.
As with Scenario 1, the cutback in public finance from this outcome will almost certainly have a contractionary effect on the macroeconomy, being an anti-stimulus as government spending contracts and cycles into the economy through multiplier effects. If this economic contraction feeds back into reduced tax revenues, or the ability to maintain interest payments comes into greater doubt, and the interest rate demanded by lenders to the Treasury will rise, with the effects on stocks and commodities similar to those discussed in Scenario 1. The longer this scenario continues unresolved, the more investors are likely to convince themselves that default is imminent, provoking capital flight from the Treasury market (as well as virtually every other US market).
Scenario 3: no ceiling increase; US Treasury suspends interest payments
This is indeed a disaster scenario, but extremely hard to map out because there are multiple feedback loops in which the causal trails-of-events quickly disappear into dark mists. At the very least, however, the US will have genuinely failed to meet its debt obligations and be in default, and US Treasury debt will more-or-less instantly drop to a D rating, signifying “actively in default.”
A D rating would turn many large institutional investors into forced sellers by law. It would not matter if investment managers thought that the debt would be repaid in time; US debt would no longer be considered “investment grade.” Some might be forced by regulations to dump D rated securities, but many other sellers would simply be following contractual agreements with their investors outlined in investment policy statements. If selling is motivated by contract law, rather than regulatory requirements, the US Government cannot solve the problem simply through regulatory forbearance, because legal actions would be forced instead by tort law, in which the US Government is merely a third party.
There is over $14 Trillion in US Treasury debt of varying maturities. True, not every holder of debt will become a forced seller, but even a small portion of forced selling is likely to have a dramatic effect on day-to-day liquidity and yields. In addition, many investors will decide to sell even if unforced, because if “the safest asset” suddenly starts losing substantial value, the most strategic thing to do is panic early.
But where to go? How does one invest responsibly when every asset is now a risky asset, and correlations are suddenly unstable again?
Some investors may have protected themselves with credit default swaps (CDSs) on US Treasury debt. These were always considered odd instruments. How does one price and hedge a default swap on the risk-free asset? There really is no straightforward way to do it. Even with a strategy that attempts to replicate the return of a US Treasury instrument through a combination of risky assets is likely to depend on correlation and volatility assumptions that will surely go haywire in the moment of a crisis.
No, the truth is that many protection sellers are not going to be able to pay their contracts, because they again simply reached for yields that looked tasty based on historical data, but whose risks actually unknown, because we are now sailing in uncharted macro-waters. Many protection buyers are going to lose a portion of the assets that they think they have insured with a CDS. If we are lucky, these sovereign CDSs were hedged with other sovereign CDSs and so losses will be somewhat controlled.
In this forced selling due to US default, the base interest rates that are used to determine the appropriate discount rate for equities will almost certainly jump enormously. Even if there is no macroeconomic effect on future earnings (which in reality will almost certainly decline), the present value of those earning streams will drop substantially as the yield on now-defaulted US Treasurys jumps several percent in a matter of days or less.
Adding in macroeconomic follow-on effects, the fall in asset values will create an inverse wealth effect, reducing consumption, pushing us into a double dip recession, where we can expect another jump in unemployment and collapse in US based consumption. Thus, on top of the massive decline in price-earnings valuations that accompany higher Treasury rates, the earnings themselves will decline due to macroeconomic contraction. This double-effect on stock prices will be devastating.
The commodity space will also collapse due to demand contraction, with the exception of precious metals, which will most likely seem one of the few “safe” stores of value in a world where the dominant world currency now convulses.
The US dollar will almost certainly drop due to both interest rate effects (a logical consequence of the covered interest rate arbitrage relationship) and due to reduced production at home. It might seem that alternate world currencies are logical places to hide, but to the extent that foreign economies depend (directly or indirectly) on exporting goods to the United States, foreign currencies may be more closely tied to the dollar than expected. Therefore, economies that are relatively self-sufficient and decoupled from the United States are the best choices. Indonesian Rupiahs, Hong Kong and Singapore Dollars, are attractive locations, possibly also Brazilian Reals, Peruvian sols, and Chilean pesos. Euros are risky, although Swiss Francs are possible. Canadian dollars may be good, except to the extent that Canada’s economy is tightly coupled to the United States.
The challenge is that the US Treasury market is so large, how will investors even think about reallocating even 10% or 20% of now-D-rated treasury debt? Reallocation may happen between asset classes (over the long term), between maturities (to the front of the curve), or between currencies and sovereigns. Part of the problem is that the size of the US Treasury market is close to or greater than the size of all other AAA rated sovereigns combined. No matter where one runs, simply there is not enough supply to absorb it, and many US investors will have to take on new kinds of risks to do it: interest rate risk, foreign exchange risks, commodity risk in precious metals, and equity risks if reallocating to other asset classes. Some investors may be stuck in a particular asset class by the rules of their mandates, and will be unable to make much adjustment.
In response to insufficient funds to pay interest, and unwillingness or inability to squeeze funds from other budgets, the US might conceivably target specific maturities for non-payment, thereby attempting to quarantine the D rating to a specific part of the yield curve, and preserve AAA ratings elsewhere. This is unlikely to be tenable for long, but is one possible short term solution.
Another out-of-the-box solution might be for the Fed to forgive a portion of Treasury debt that it holds, effectively monetizing that debt. This would solve the immediate problem, but likely create outrage in Congress and the outcome could be a Congressional revision of its mandate to prohibit similar activities in the future.
More disturbing is that there is little indication that anyone has seriously thought through what the consequences of this scenario would be. The more I have tried to dissect it, the more I am convinced that the current brinksmanship in Congress the financial equivalent of the Cuban Missile Crisis. But, during the missile crisis, people at least knew they should be scared.
Strategy implications
The most important takeaway from this analysis is that all scenarios are bad for stocks: the differences are only of degree. I have thus reduced or eliminated most of my stock exposure. An important question when all scenarios are negative for stocks is whether market participants already realize this and have internalized it (“discounted it” in market-speak). As I watch and read the news, I do not see anywhere near the range of panic or sell-off that would indicate that market participants have thought this through and hedged or reduced exposures accordingly. Rather, the assumption is that things will get resolved because “default is unthinkable.” But even in the most optimistic scenario, interest rates will rise and risk premia will rise. And as someone born on September 11th, remember every year that “the unthinkable happens.”
The silver lining is that after the deluge, risk premia and interest rates are likely to rise to rates that are far more appealing than they are today, and so having cash (particularly cash in mattresses) is likely to be beneficial. Indeed, for tax-advantaged accounts, the penalty of perhaps missing a relief rally is probably a small price to pay for the opportunity of having cash to deploy if things get bad.
Another silver lining is that Congress probably has little stomach for the kind of crisis that their intransigence can unleash. Although it will be far far better if they can come to an agreement, Congress may well relent and raise the ceiling quickly if financial Armageddon truly starts to unfold. At that point, both fixed income and equities are likely to be yielding attractive rates of return for those who have the cash available to buy them.
For commodities, the most important effects have to do with the macroeconomic fallout. As with equities, all scenarios are ultimately contractionary. Commodities are likely to be less dramatically affected than equities (on a risk adjusted basis), because while they respond to the macroeconomic contraction effects, they are less affected by the valuation effects that affect equities. In addition, demand for commodities is still likely to come from emerging market construction, and some emerging markets will be grateful for the inflationary relief caused by a collapse in US consumption.
Gold and precious metals is one location that investors will search out as an alternative substitute for their US Treasury debt. Foreign currencies are another, particularly those with AAA sovereign ratings and economies that are less intertwined with the US.
The major risks are truly to the downside, and although a relief rally could pop prices upwards in the immediate aftermath of a political agreement, it is then likely to be followed by contractionary fiscal policy as the agreement. Having cash available as dry powder over the next month or two is likely to provide attractive options to buy without sacrificing too much short-term return. The only real wrinkle in this strategy is the extent to which raising cash by reducing exposure creates tax liabilities. |
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