Posted on Tuesday, July 19th, 2011
Prior to 1917, each U.S. debt issuance was authorized by Congress. In order to more easily fund World War I, the method was changed and then modified again in 1939, with the current law authorizing Congress through the Treasury to issue debt as necessary to fund government operations as long as the debt limit (or ceiling) is not exceeded.
As everyone knows, this debt ceiling will be reached on August 2nd. In the past, it has been raised routinely as the total government debt approached the self-imposed limit. For example, it was raised 10 times during the past 10 years.
Today, it serves as a double-check on tax, spending, and borrowing priorities. Usually, the raising of the debt limit is a non-event that barely warrants a mention in the news, but because of the extremely large deficits the government is currently running, it has become a political leverage point. The debt ceiling is a bargaining chip that many are using to try and get their way on the broader issues of the role of government, how we pay for it, and who pays for it.
With each passing day, a comprehensive solution that both political parties would accept becomes more unlikely. The expected outcome is a combination of small, targeted spending reductions possibly with a small revenue increase. If that can be accomplished, we believe there should be limited market implications assuming the agreement is not smoke and mirrors.
The President and Congress need to reach consensus several days before August 2nd in order to get legislation passed in time to avoid market disruptions. However, anything short of a 6-12 month spending/tax deal may have short term market implications, but we don’t know, and no one else does either. While a real default is unlikely, there are many implied obligations (veteran benefits, Medicare, etc.) that could go unfunded.
All these factors point to an increased likelihood of a less than optimal outcome, and the purpose of this communication is to let you know how we’re thinking about the investment implications.
The bond market could react negatively to a poorly constructed deal. But even with a worst case scenario, we’re not convinced that bonds would drop significantly for any extended period. Yes, some institutional investors may be required to sell U.S. obligations if the U.S loses its AAA rating. And, yes, that may create short term market imbalances, but long term, even with a permanent rating decrease from S&P and/or Moody’s, where’s a bond investor to go? Europe? Australia? Japan? We don’t think so.
Many market pundits are focused on the stock market implications of stalled debt ceiling negotiations. We’re not. Why? Because stock market investments are for 10 years and beyond. Short term stock market moves may be worrisome, but I’m confident we’ll be talking about something else in 10 years. Our position today is to maintain our stock allocation.
We still want to be prepared for a bad outcome from Washington, and we believe we are. Our bond allocations are still short term, high quality, and even with a market disruption, we would expect to receive our principal in short order. We’ve reviewed our current holdings and believe we’re positioned as well as we can be for the short term uncertainty ahead of us.
The political process is ugly and necessary, but not too surprising. Take a look at our political commentary in our quarterly e-letter from April of this year, and you’ll see we were expecting a version of what we’re experiencing now.
Finally, it’s hard to put all our thinking in one communication, so give us a call if you want to talk more.
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