thinking about a US default

a small boat out on the ocean

At the moment, the hardest investment task for me, as an American, is to distinguish between emotional involvement in the political struggle now going on in Washington, on the one hand, and the stock market consequences of apparent gridlock in Washington, on the other.

An equity portfolio manager, amateur or professional, is like a sailor in a small sailboat out in the middle of the ocean.  If you see a storm coming, you can spend your time cursing the wind and railing against the lightning–and achieve some emotional satisfaction.  But you’re better off taking in some sail, tying stuff down, putting on a raincoat, and doing whatever else prudent sailors do in circumstances you have basically no control over.

my assumptions

Two factors make the deficit situation hard for me to handicap.  The first is that, like most equity investors in the US, throughout my career I’ve regarded politics as a mild negative for stocks, but basically irrelevant.  So I don’t know much about the world inside the Beltway.  Also, today’s argument isn’t about who gets a larger relative share of an expanding pie to distribute as patronage to the people who voted for him.  It’s about everyone giving up something.  That’s a much harder discussion.  Nevertheless, you have to assume something.  For me,

1.  If S&P’s word is good, and I think it is, US Treasuries lose their AAA credit rating sometime soon.   This has two consequences that I can see:

–the US will have to offer a slightly higher interest rate to sell new debt, and

–depending on how their contracts are written, some bond managers will be unable to buy new Treasury debt, or to hold as much of it as they’ve done in the past.

2.  Washington may have to be forced into compromise.  This could happen in one (or both) of two ways:

–In early 2009, it took a large stock market drop immediately after Republicans voted against countercyclical fiscal stimulus to get them to change their minds.  That may happen again.  Maybe the Treasury refinancing scheduled for August 4th won’t go well.  Or maybe the stock market will drop.

–The government may stop sending out transfer payments, like Social Security, or checks to government employees.  The resulting tons of angry phone calls and emails to congressmen would likely focus their minds.

By the way, there’s been some discussion in the press as to whether government computers are flexible enough to make some payments, like Social Security or salary checks, but not others, say, payments to defense contractors.  It’s not clear that they can.  So the choice may be either to pay everyone or no one.  Federal government offices may have to shut down.  Not great for a sputtering economy.

In addition, money market funds are becoming more liquid–and withdrawing repo financing from EU banks–in preparation for possible redemptions of their own on a government debt downgrade.

Two conclusions:

–events will force Washington to raise the debt ceiling in short order;

–there could be a temporary, but possibly sharp, stock market selloff before that happens.

what I’m doing

Worries about domestic politics can play out in three ways, I think:

1.  through a weaker US dollar.  This is already starting to happen; look at the ¥/$ rate.  My guess dollar weakness continues.  My US holdings are selected to benefit from dollar weakness, however, so I don’t have to defend myself here.  In fact, I may even gain something.  A secondary concern is that investors in foreign markets will orient their holdings away from dollar earners, but I don’t have enough exposure to worry.

2.  through higher interest rates.  Since bonds are substitute investments for stocks, higher rates will likely put some downward pressure on stocks.  But US stocks already seem priced for much higher interest rates than we have at present, so I’m not too concerned.  Other than avoiding financials–and I own almost none–I don’t see anything I can do.

3.  through a stock market selloff–a mini-panic.  For an institutional equity manager, instructions from clients will likely not allow holding more than very small levels of cash.  So he just grits his teeth and rides out the storm.  A taxable private investor has to balance the certainty of triggering a capital gains tax vs. the possibility of selling today and buying back, say, 15% cheaper in a month.

My decision?

I’m looking through what I own to try to identify the clunkers hiding there so that I can get rid of them.  I’m also eyeing my biggest positions–both individual names and industry groups–to see what I should trim.  This is what I usually end up doing in times of stress–cleaning up my portfolio with the long term in mind.  I try to do this every day, but I find storm clouds on the horizon make me a more critical observer.

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