On June 23rd “The Economist” magazine published an article titled,”The Mother of all Tail Risks,” that summarizes the August 2011 U.S. debt ceiling issue. The magazine points out that a U.S. technical default would convulse markets. Beyond that, the article points out that nothing else is certain.
The story discusses issues that could occur if a deal cannot be reached before August 2nd thereby triggering a U.S. debt default. The article points out that a country default would not confined to the European side of the Atlantic. As a result of this issue, trading in credit-default swaps on treasuries has picked up with the price of protection increasing.
The article points out that beyond this issue, there is profound muddle about what default would entail. I believe it is safe to say that a default would have serious consequences and create issues that likely cannot be fully anticipated. I recommend a read of the article for a summary of some of the specific issues that may be created by an August 2011 default.
The irony of the situation is that politicians on both sides of the isle approved bailout spending that allowed banks and other financial institutions to avoid default both within the U.S. and outside of the U.S. However as of today, a political agreement in Washington D.C. has not been reached that would prevent a default from happening to the U.S.
The republicans are pushing for ongoing tax decreases and a massive spending reduction raising fears and making the argument that if this not done the worldwide treasury market will implode causing U.S. borrowing costs and other nasty outcomes to occur. The republican dogma is reasonably consistent with the Austrian school of economic thought which suggests government should be smaller and the chips shall fall where they may in a pure free market economy. The democrats point out that a debt default would be a catastrophic.
The economic and political backdrop to this issue also revolves around a Keynesian economic viewpoint that due the ongoing economic weakness, now is not the time for a massive cut in government spending in an effort to balance the budget. The Austrian economic school-Republican view is the opposite in that the best way to save and grow the U.S. economy right now is to keep taxes low, reduce the size of government and cut spending. In our view, the battle here is about politics that are couched in economic terms. I believe the risks are too great to play politics here. However I am confident my opinion will not sway the debate or impact the political tactics being deployed here.
As of now, a compromise has not been reached that would mesh these views in a way that allows for a debt ceiling increase. At this juncture, I am also confident I cannot reliability predict the outcome here over the next month. While only a guess, my best guess is that a last minute compromise will be eventually reached.
As a result, I believe the following will occur between now and August:
1) The story is highly likely to stay in the news which increases the probability that volatility increases in the global financial markets (stock, bond, commodity, currency, etc.).
2) I expect volatility to incrementally increase with the passage of time over the next 30 days and potentially beyond depending upon the eventual outcome here.
3) The terms of the compromise will impact the volatility looking forward. If for example, the issue is moved 90 days into the future, volatility may decrease based on such an outcome only to rise further as the calendar is moved toward a new deadline.
What should you do?
Whether you are an individual or professional investor the answer depends upon your unique circumstances. I will not try to forecast all of the possibilities here. What I recommend investors do is to think clearly about their overall investment strategy and how they might react to and manage this uncertainty. For stocks, at a minimum I would review the balance sheet, leverage, liquidity, solvency, cash and cash flow positions, etc. of companies I hold. For bonds and other assets, I would do the same, which is to review the underlying fundamentals-financial position and other factors that may impact these securities. In essence, do the homework on individual holdings.
Beyond the work done at the individual security level, I recommend that investors consider how the overall systematic risk may affect their portfolio or assets as a whole from a pricing and market liquidity vantage point. In other words, consider how overall markets may be affected and how will you react. For example, what will you do if spreads increase in the credit markets and pricing is negatively affected in the equity market?
If you are a CFO, you should do a similar exercise in terms of thinking about liquidity, market conditions, deal-making and funding costs, etc.
For now, the story will clearly stay in the news. In summary, I believe it is wise to be as well prepared as possible for a negative tail event even if you consider the probability to be low.
Source: “The mother of all tail risks”, The Economist magazine, June 23, 2011