US Debt Ceiling – Prepare For the Worst…

Equities have certainly started 2013 with an impressive tear as each day they edge a little higher. Optimism is the order of the day and bullish sentiment, whilst not at excessive proportions, is certainly well entrenched.

In the U.S. investors it seems are presently assuaged with the last minute solution reached in the first hours of January with regards to the fiscal cliff situation. The 4Q quarter’s earnings season is currently underway and there have as yet been no shockers.

Meanwhile ,in Europe, it seems that Merkel, Barroso, and even Lagarde, are finally talking unison, stating that the worst of the crisis is behind us. In Japan, Shinzo Abe‘s new inflation inducing policies look to be being taken seriously and the yen is finally trending favourably for the country’s exporters – hovering close to the 90 level for the first time in a number of years. Bond yields remain depressed everywhere, even in the Southern European nations and so it seems investors are satisfied with holding British, French and US debt what is actually negative real yields (after discounting for inflation).

There’s no doubt Europe is no longer under the same level of pressure it was last year before “Super” Mario Draghi stepped in to help with a commitment to keep certain European sovereign debt yields at reasonable levels. There’s also no doubt that Japan and China are finally back on track. But, unfortunately, there’s also no doubt, that US politicians are squaring up for another almighty squabble over the forthcoming debt ceiling issue at the end of March.

The last minute deal reached on January 1 concerning the fiscal cliff most certainly was not a final solution. Ninety percent of the problems have still to be debated and solved with the US Treasury facing perilously close to their self imposed debt ceiling. Only account fudges by the Treasury Secretary is keeping the wheels motoring and various Govt dept’s being paid and there is serious talk by some of the more hard-line of the Republicans in allowing the US to actually default!

The table below depicts the total US outstanding debt amounts as of December 31, 2012. With the current statutory debt limit set at $16,394,000 million and the total public debt outstanding at $16,393,975 millions, there is just $25 left. Even if the US Treasury still has that last $25, it won’t certainly suffice to pay all the bills due!

According to the US Treasury, there are some “extraordinary measures” that allow the Treasury to continue to manage its financial commitments until mid-February. After this, unless a compromise is found, then the financial engineering tricks will be no more and the US will effectively default for the first time in more than 200 years.

As Obama and other Democrats have openly stated, it would be a calamity of epic proportions if the US government defaulted on its payments. The Treasury would have to decide between paying bondholders, paying the military, and transferring funds to social security recipients. No matter the choice, a default would create social unrest and turmoil in markets and quite possibly irreparrably damage the US’s standing in the Intle debt markets.

Republicans understand the risks but want to capitalise on the event by forcing the President to make a deal which evaded them at the time of the fiscal cliff negotiations. They want the President to commit to cuts in government spending instead of tax increases in exchange for a deal for the debt ceiling. Obama on the other has stated that he is unwilling to negotiate on this route.

We believe a deal will ultimately be reached as both parties have much to lose if they don’t compromise but recent history also tells us that a non tortuous and drawn out deal is very unlikely. As happened in 2011 & the end of 2013, Congress will likely be debating the matter right up until the very last. The debt ceiling probably be solved but not without gyrations in the market along the way and attendant high costs.

Fitch ratings agency has just recently warned that the coveted AAA credit rankings of France, UK and the US are under threat as economic growth is sluggish and debt levels remain very high. In the US, Public debt currently sitting at 105% of GDP – a level last seen at the end of the post-World War II era and which largely was the result of reconstruction efforts.

When President Clinton left the country in August 1997, the debt ceiling was $5.95 trillion. Then, President Bush Jr. changed it seven times to the final level of $10.615 trillion on his exit from office. As the US economy was growing during this period, debt to GDP only rose from 75.9% to 78.8%. From 2008 until today, the debt ceiling was changed several times again and now sits at $16.4 trillion and rose to 105% of GDP.

Given that we believe there is a serious bubble in US Treasuries, then this upcoming event may just be the straw that breaks the camel’s back and makes investors realise that buying the debt of a heavily indebted, dysfunctional nation on negative real yields is utter, utter madness. It is also risky to be a bull of equities under these circumstances. On July 22, 2011, the S&P 500 closed at 1,345.02 and in just two short lost 16.7% – in a large part as a consequence of the debt ceiling negotiations then. It took the market almost eight months to fully recover. With the prognosis of such a hazy immediate future, it may be wise to insure your portfolio with some put options or trim positions as we have done, taking profits on exceptional outperformers in recent weeks.