Moving Chess Pieces
David R. Kotok,
October 7, 2013
“As the political strategists move their chess pieces, the government shutdown is morphing into the bigger long expected fight about the debt ceiling. The agreement to pay government workers back pay, and the recall of most defense workers next week, basically means the impact of the shutdown is quite limited and no longer a political issue of great importance. The real fight is now focused on what concessions can be extracted for raising the debt ceiling and avoiding default – supposedly on October 17th, but certainly by November 1st when the next large social security payment is due.”
– Michael Drury, Chief Economist, McVean Trading, October 6, 2013
Fishing Pal and Global Interdependence Center colleague Mike Drury has correctly identified the change in pressure points. Having suffered political heat, Republicans and Democrats have found ways to shift the intensity of the budget fight. The non-game game continues as we are moving to the debt limit fight where the Republicans perceive themselves as holding a stronger advantage. They’re wrong. Obama does not run for re-election. They do. So do the Democrats, and this is all a game of finger-pointing in order to have the voters find fault with the other guy in next year’s elections. “What a country!” said the comedian Yakov Smirnoff. Talk about an understatement.
The United States is the world’s largest debtor (almost $17 trillion), and the US dollar is the world’s reserve currency. Actual default on the payment of interest and principal is an unthinkable course of action. Tom Donlan of Barron’s writes that the US must borrow about $700 billion over the next year just to keep ”doing everything it did last year.” He then adds that it “must borrow more than $5 trillion in the next 10 years” and “more than $14 trillion over the next 25 years.” These projections do not include rising “inflation, higher interest rates, slower GDP growth, longer life expectancy, and new spending programs.” Default and cascading consequences are not factored into the Donlan estimate. If we actually do fail to pay on our Treasury debt, those future year’s borrowing numbers will become much larger.
US market agents focus on the US Treasury interest rates and see them trending lower since the crisis evolved. They do not often consider how the market is pricing US default risk. Most of us are US-centric and focused only on the yield.
Global investors think differently. We can gauge their view by examining the pricing of the credit default swap (CDS) of the US. It is denominated in euros and trades outside the US, with major market making in London. Foreigners view the US interest rate as the yield they will receive, less the cost they incur by insuring that the US does not default. That is what the CDS is about. Its price is rising and has surged up sharply over the last two weeks. It spiked again today. Foreigners do not like what they see in Washington any more than we do. That is why they use insurance and hope they do not need it. Note that the US CDS market is not as liquid as other CDS markets, so reference prices have to be taken with a grain of salt. That said, they are certainly up from where they were before these political shenanigans started. They are a warning sign. Will Washington even take notice?
Another indicator of default risk is the spike in yields on the very short-term Treasury bill. It was trading to yield a pittance of 3 or 4 basis points. It spiked as high as 20 basis points before falling back to a trading range in the 12-13 level. That was last week. Assurances by politicians that they will not let the US default have had only limited effect.
So what is an investor to do?
If you actually believe that the US will default, then you need to prepare for a catastrophic event. Markets could experience another TARP moment like they did about 5 years ago.
In our view the US will not default. It has an absolute ability to pay. This is a political fight, not an economic one. The credit of the US is not the same as Detroit’s or economically risky like Puerto Rico’s. The country is not dismembering like Argentina or unable to support budgets like Greece. Comparisons between the US and these others are not valid.
That said, the US could run out of cash by November if it cannot legally borrow. We do not fully understand the October 17 date. But we do see November 1 looming as a massive entitlement payment date and we do have November 15 as a key date for substantial payments on US Treasury bonds and notes. No increased debt limit means the government would have to choose who gets paid and who is deferred.
The failure to authorize borrowing would cause an immediate budgetary reduction of roughly 4% of GDP. That is an annualized rate. That is also a massive and abrupt shift. Our citizens will not like the fallout. We would encounter a replay of the recent airport-slowdown reaction with much greater intensity. Our politicians know this, so they may play the brinkmanship game, but in the end they will not permit default. That’s our view. They never have defaulted in more than two centuries of American history.
That said; the risk is higher than zero even though it is quite small. We do not expect default. But we recognize that some lunatics are driving the nations’ policy decisions and some of them are willing to experience a default. We elected them. Let’s not forget that.
So what are we doing at Cumberland? We are a manager of separate accounts. If a client says, “Take me out of the markets,” we do it. If a client asks us today what we think is best for them, we suggest that they be in the markets, not out. So we may be sellers when a client determines to leave the markets and overrides our discretion, changes a strategic view, and orders liquidation. That has happened to us a few times in the last two weeks, and it usually indicates that selling pressure is actually peaking.
We are on the other side. We think the US does not default. We believe that any rocky period in markets will be temporary. So we want to take advantage of this period of weakness in order to reposition portfolios.
At this time, we are targeting being invested in the US stock market. We are not there today but are heading that way. We want to see all equity-allocated cash deployed in exchange-traded funds (ETFs). Furthermore, those ETFs have been selected for a recovery rally that will take the market to new highs. We believe that the S&P 500 Index will cross $1,800 by next spring. We expect earnings on the S&P 500 to exceed $110 in 2014.
In economic terms, the budget battle and debt-limit showdown, with all the political shenanigans either side can muster, will be a setback in broad-based GDP (gross domestic product) accounting terms. Since this setback takes place in the middle of a quarter, there will likely be a recovery once matters are resolved. And we know that the clock is ticking, so they must be resolved. By the middle of next year, a historian might look back at data for the fourth quarter of 2013 and conclude that very little happened.
Meanwhile, the profit share out of the US GDP remains very high. That profit share translates into earnings momentum and reflects itself in the valuation of stocks. Stocks are neither cheap nor rich. They are sort of in the middle ground.
The Fed (Federal Reserve) is more worried about the real economy than it is about the price of the stock market. It knows that the real economy has suffered a setback because of the political brinksmanship of Congress and the White House. That means any tapering will come slowly and tepidly.
We expect the tapering issue to continue to surface at the Fed. Tapering, when it takes place, will be staged in incremental steps over a period of 1 year, 18 months, or even 2 years. Tapering from $80 billion to zero at a pace of $5 billion per meeting would take 2 years, given the Fed’s schedule of 8 meetings a year. Such an announcement would be well received by market agents. The Fed could reserve the ability to change the path at any time and would likely do so, but it would also start on a path of gradualism that would be calming to markets. Will they? “Only the Shadow knows.”
The Shadow may know the outcome of the debt limit and budget fight, too, but he ain’t tellin’. It is this simple: We either default, and our politicians do lasting damage to our country. Or we don’t, and markets resume a trend higher, and we go on in our unique American political way. We will know soon. I’m betting on the latter. Right now we are holding a cash reserve and deploying it in periods of weakness.
David R. Kotok, Chairman and Chief Investment Officer
Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.
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