Recommendations For Investors On U.S. Debt Deal Uncertainty

 

There has been so much media coverage & uncertainty surrounding the U.S. debt ceiling, that many investors have become nervous and on edge.  The entire circus has sent the markets on a roller-coaster ride, moving up and down in the last few months giving back a lot of the gains of the year.  With just two days left for the U.S. to raise the debt ceiling, investors are unsure of what to do about the situation and a potential U.S. debt default.

 

Plan For Possible Scenarios

As a value investor, I worry less about macroeconomic level events.  Although what I usually do is use knowledge of economics to identify potential areas or periods, where opportunities may arise (for buying investments at a discount), and then plan for them.  As I’ve mentioned before, investors can plan for the possible outcomes of the U.S. debt ceiling debacle, and not be caught off guard by either one, while capitalizing on opportunities that may arise.  So lets take a look at the possibilities, probable outcomes, & implications/effects.

 

A Possible U.S. Default

I do not rule out the possibility that the U.S. may default next week.  However, I expect that a deal will likely be approved before the deadline and that the U.S. will not default. No one really wants to see the U.S. default on their debt, and both sides have been working around the clock to reach a deal that can be approved.  But even if they don’t default, the damage has already been done to their reputation. By allowing the problem to go on for so long and get so close to the deadline (without having a deal approved), the international community and investors have lost faith in the U.S. government.  The once solid reputation of the U.S. has now been put into question. It takes an extremely long time to buildup a good reputation, but it reputation is also something that can quickly be tarnished.  The market declines have been perhaps the greatest indicator of investor sentiment.  Investors have recognized the real possibility that the U.S. government is actually capable of defaulting on their debt, where once-upon-a-time the thought wouldn’t have crossed people’s minds.

 

A Possible U.S. Ratings Downgrade

The currently proposed $3 trillion in savings might calm the financial markets, but it may not be enough to avoid a downgrade by rating agencies.  The AAA rating of United States may still be downgraded by Standard & Poor or Moody’s.  Last week Standard & Poor reiterated that a $4 trillion reduction in the deficit would be a good sign that Washington was serious about putting the country’s finances in order. If the rating agencies do downgrade America’s top notch AAA rating, it can be expected that the U.S. Treasury yield (bond rate) may increase. The amount that the rate increases by is dependent on whether the downgrade and/or default would come as a shock to investors, and how much they have already priced into Treasuries.  Treasury prices have continued to decline in recent weeks (and rates have correspondingly risen), so my personal expectation is that investors have already priced in a significant amount of risk related to a potential ratings downgrade.  A spike in yields would likely be temporary and they would return closer to now current levels. Because investor actions dictate the prices & yields, I do not rule out the possibility that rates would remain high for an extended period of time.  Treasury yield increases mean higher borrowing costs for the U.S. government, due a perceived increase in risk.  This in turn affects the borrowing costs for businesses that operate in the U.S. Higher borrowing costs translate into lower corporate profits and more difficult business environment.  How large of an immediate effect this will actually have on individual business is anyone’s guess, but I expect it to be moderate as the market seems to have priced in most of the risks of a downgrade.  However, if U.S. debt levels do not improve over the longer term, it will have a more sustained impact on costs & inflation, which is a more worrisome prospect.

 

Equity Markets

There are only 3 directions the markets will move – up, down, or remain at current levels.  If a deal is approved before the deadline, it is expected that the markets will rally and move up on the news.  If the U.S. defaults on their debt, it is expected that the markets will react negatively and decline.  How much the market will decline is anyone’s guess.  However, I expect short term volatility to be high in such an negative event.  Due to the major role of the U.S. dollar in global financial systems, governments & investors across the world fear that there could be severe instability. It is this fear that will push markets and equity prices lower if the U.S. cannot raise the ceiling by the deadline.  In addition to the markets moving up or down, it could also fluctuate near current levels. This scenario is possible even if a deal is reached, as investors demand higher returns for bearing greater risk, pushing the cost of equity higher (in addition to the cost of capital rising).  This demand for higher returns, translate into lower than normal market equity prices, possibly offsetting any positive effect of a debt deal approval.

 

Investor Recommendations

It is recommended that investors consider what actions to take under each scenario, and weigh the costs & benefits of such actions. If equity prices significantly decline, companies themselves will likely continue to be profitable.  Selling prior to a decline would give you cash to re-acquire (or acquire new holdings) at lower prices.  Although they may or may not fall below your original average cost, they are likely to be at a substantial discount to intrinsic value (on a general basis).  However, selling dividend paying stocks, corporate bonds, & preferred shares, mean you won’t be collecting payments for that period. It may also be possible that corporate bonds may not mirror declines in equities/stocks and therefore might not give much of a discount.  But there is also a likelihood that they will decline and be available at discounts.  However, if a deal is approved after voting and markets rise, then additional profits from a rally would be forgone by having sold.  Investors should determine the most suitable course of action for their situation, taking into account the possible scenarios.  Investors should be satisfied with the decisions they make in all outcomes, and not be caught off guard by the different market outcomes resulting from a U.S. debt deal being approved or a default, or rising costs of capital on corporations over the longer term.

 

Debt Talk Update

Late today (Sunday July, 31, 2011), Senate Majority Leader Harry Reid signed off on a deal to raise the debt limit. The deal requires approval from his caucus, and he also needs backing from Senate GOP leaders, followed by a majority approval of the House.  The agreement reached by congressional leaders and the White House calls for approximately $1 trillion in spending cuts over 10 years up front, and another $1.5 trillion worth of deficit reduction based on recommendations of a new bipartisan committee. According to a senior congressional aide, the Senate will likely vote on the proposed agreement on Monday. Leaders in the Senate announced the agreement on the deal, but support remained especially uncertain in the House of Representatives. President Obama in a speech on Sunday night, urged “members of both parties to do the right thing and support this deal” and approve it with their votes over the next few days.

Even if the agreement is approved on Monday, actual debt levels still remain the same, which is the larger concern.  Approval on the deal still remains a promise.  There will still be lots of work that needs to be done in order to actually reduce the U.S. debt which currently stands at about $14.3 trillion.

Thanks & Happy Investing! — The Investment Blogger © 2011

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