Default vs. Downgrade
The acrimony in Washington over raising the debt ceiling has made for interesting (albeit depressing) political theater. As the parties have repeatedly failed to agree on every budget austerity deal, and with rating agencies breathing down their necks, there is good reason to be a little fearful of what will transpire in the next week.
Despite the fact that both sides are posturing as if they are entrenched on their fiscal demands, we believe all parties will do anything to avoid a default on U.S. debt. One can make the argument that a tea party Republican was elected into office on the premise that he would not vote for any tax increase. Similarly, any Democrat who even thinks about cutting entitlements might believe that he would not be re-elected. However, our feeling is that the popular opinion now is more concerned about the near-term risk of default, instead of longer-term spending issues. That’s not to say that come election time, the budget part of the vote won’t come back to haunt the elected officials, but for now, the people largely agree that we should avoid default at all costs. We should also note that the government routinely votes to raise the debt ceiling. In fact, this would be the 85th time since the 1950s; there were 9 such raises during the 2000s. What makes this vote unique is the gumption our legislators have deployed to rein in government spending, which is a good thing.
Our belief had been that virtually any deal to avoid default would be sufficient to avert rating agency downgrades of U.S. debt from AAA. Recent mutterings and threats from the rating agencies now lead us to believe that a lukewarm budget deficit reduction provision attached to a debt ceiling raise could lead to a downgrade. S&P seems to be explicitly targeting $4 trillion of deficit reduction (over 10 years). While we should be cheering, as Congress should have the finish line in sight, with a clear objective, the House and Senate have each trotted out proposals which seem to fall far short of $4 trillion.
So, as it stands now, the possibility of a downgrade of U.S. debt is real. It’s possible that the rating agencies are simply trying to force the government’s hand and won’t follow through, but we wouldn’t ride that theory to the bank. The reality is that our deficit spending and debt levels do not reflect AAA standards. The chart at the bottom shows 13 major countries which are currently rated AAA. All have lower budget deficits AND lower net debt levels, as a percent of GDP. All are FAR lower, with the exception of the UK.
In case you were wondering about historical precedent, Canada was downgraded from AAA in 1994 thanks to a lousy fiscal situation and stagnant economy. It since recovered its AAA rating, thanks to—no surprise—a cleanup of the federal budget and a good economy. Same for Australia in 1986; it regained its AAA rating long ago. Same for Finland and Sweden in 1991. The UK staved off a downgrade from AAA in 2010 thanks to relatively harsh spending cuts and tax hikes, but still faces a downgrade threat thanks to a stagnant economy. Japan has faced three downgrades since 1998, from AAA to AA- currently.
What would be the ramifications of a downgrade? History (of other downgrades) has shown that the effects on interest rates and currencies have been minor and temporary. The secondary effects are where the uncertainty lies: will institutions which can hold only AAA-rated securities be forced to sell treasuries? Other effects could come from “pre-refunded” municipal bonds, agency bonds, or banks needing to raise capital.
It is this uncertainty that should lead to volatile stock prices over the coming week. So far, the bond market is taking the risk in stride, with very modest effects so far. The dollar has been somewhat weak versus most currencies, though no weaker than it was back in early May or early June. Both U.S. bonds and the U.S. dollar have historically been beneficiaries of a flight to safety, whereas stocks are normally victims. In the medium-term and long-term, stocks will trade based on the outlook for the economy and corporate earnings. Any pause in the economy that results from a downgrade would be negative for stocks.
However, we hasten to add that corporate America sells to the world, and while the rest of the world has issues too, growth is still robust in most places. And our primary thesis on the U.S. economy is unchanged: there is a ton of untapped liquidity and profits in corporations which is ready to be put to work. The only thing standing in the way of a lot of capital being invested, and workers being hired, is confidence in the long-term of our country. At the risk of sounding too political, we believe that entitlement reform is critical to gaining this confidence.
On the positive side, federal government revenues are coming in ahead of schedule and spending is below budget in recent months.
The next step will be the votes in the House and Senate on their respective bills, on Wednesday. Of course, we’d like to hear some kind of answer from Congress on why they don’t appear to care about S&P’s demands, but who knows if that will happen. In the meantime, we will continue to monitor the developments, while digging into 2nd quarter earnings reports, which have been quite good so far.