Default, Downgrade or Deal?

Marc Fovinci,CFA , is a portfolio manager and co-manager of the firm's fixed income strategy. He is a principal of the firm and a member of our Investment Policy Committee. 


The logjam over raising the U.S. federal debt ceiling looks as if it will break up at any moment. Both sides of the aisle are displaying some willingness to compromise, and public opinion polls overwhelmingly favor this outcome; however, politicians still have a way to go before a bill is actually passed. 


As the August 2 deadline looms, the Obama administration has said that the Treasury will have insufficient funds to pay all its obligations, forcing it to prioritize payments. Fortunately for holders of U.S. Treasury debt, they will be paid first. Despite murmurs from some politicians to the contrary, the consequences of a default on debt of the United States would be too expensive, far-reaching, and long-lasting for policymakers to tolerate. One only has to look at Greece (which has not yet defaulted on its debt, but is likely to in the future) to see the financial repercussions for a country appearing close to defaulting on its debt. The absolute necessity of passing the debt ceiling makes it the political lever for the bargaining we see now. 


While speculation of default makes good headlines to sell newspapers, the issue for markets is not whether the debt ceiling will be raised, but what deficit reduction is ultimately implemented. It is the story of Goldilocks and the Three Bears: the market needs a plan that is "just right." The plan needs to reduce the deficit neither too quickly nor too slowly. It needs to be neither too small, nor too big.

Possible actions of the rating agencies have made this issue particularly interesting. Moody's put the U.S. government on its "watchlist" for downgrade due to delays in passing the debt ceiling; however, Standard & Poor's placed them on their watchlist not only for the debt ceiling, but for the high level of debt outstanding. If Standard & Poor fails to see a substantial deficit reduction package, they will downgrade U.S. Treasury debt within 90 days. A downgrade would raise the cost of issuing future debt and put additional pressure on Congress and the Administration to cut spending and/or increase taxes. 


We expect the debt ceiling to be raised, though perhaps on only a short-term basis. While details remain scarce, a $2 to 3 trillion deficit reduction package (over 10 years) is likely to be enacted. Presuming the absence of rating agency downgrades, stocks could rally on this news. Bond yields might increase modestly but show little change overall, given the Federal Reserve's continuing easy money policy. The future pace of economic growth will likely be modest due to the necessary fiscal drag of deficit reduction, the depressed housing market and still-healing financial system. Given our outlook for continued earnings growth and less uncertainty after debt ceiling passage, we continue to favor stocks over bonds. 


Best regards, 



Marc Fovinci,
CFA 
Principal 


The information provided herein is for educational purposes only and should not be construed as investment advice or as an offer or solicitation. Not all securities are suitable investments for all investors; therefore, Ferguson Wellman Capital Management will not necessarily implement any particular strategies discussed herein for all clients. We recommend that you discuss questions regarding your individual portfolio and investment strategies with your portfolio manager.