The United States Government is shut down and the risk of defaulting on U.S. debt service grows stronger every day. Republicans and democrats are engaged in a fight with each party trying to come out looking like the victor. The media is writing and reporting worst case scenarios, causing fear amongst many investors. Meanwhile, the market has been declining modestly while the political posturing continues.
Granted, this is a big story and could have huge ramifications if the U.S. defaults, but investing is all about probabilities, not certainties. I believe the probability of default is exceedingly low for a few reasons. As a result, a market pullback in response to debt negotiations presents a buying opportunity for investors with a long time horizon.
No One Wins if the U.S. Defaults
This is an important factor to remember. Despite the almost child-like bickering going on in our dysfunctional government, nothing changes the fact that a default would be bad for Americans, Investors, every politician in D.C. and the U.S. and global economies.
What is happening is both parties are trying make the other one believe they are willing to walk away from the negotiations and let a default happen. If one party can get the other one to believe they are willing to let a default happen, they will get more concessions from the other side. The ramifications of this will be that the market could extend its pullback as each side tries to gain leverage over the other.
Because this is a no-win situation for all parties involved, I do not believe we will default. This arguing about the debt ceiling is just more noise for investors to deal with. The ramifications of a default would be far reaching and negative for the markets and the economy. Both Democrats and Republicans are just trying to figure out how to settle this and claim victory. But make no mistake, if there is a scenario in which no one wins then the likelihood of that scenario taking place is very low. It’s basic human nature. Would each party rather get a little of what they wanted or nothing at all?
For this reason, there will almost assuredly be a deal in place before a default occurs. Although, the fighting will most likely go to the 11th hour before a resolution is passed. I am politically agnostic as my main concern is how actions in D.C. will affect the markets and economy so I’m more concerned about the effect the continuing negotiations will have on the market than I am with what side will “win.”
Additionally, the dollar is the world’s reserve currency. A U.S. default would not only be bad for the U.S., but economies around the globe. Europe is in the very early stages of climbing out of recession and a U.S. default could plunge them back into recession territory. The U.S. is better off with a healthy Europe, not to mention emerging markets, which would also be negatively impacted by a default.
If the U.S. was going to default, you’d expect to see it reflected in the 10-year Treasury rate. But the rate is off its high and stands at 2.6%. Compare this to Greece when they defaulted, their long-term rate topped 20% at one point. Clearly the bond market is not worried about a default and I’ll trust the market over the press any day.
Servicing the Debt Without Congress
It is important to understand what a default actually is. In the U.S. government’s case it would be missing an interest or principal payment due to bondholders. That’s it. The media has decided that not meeting “obligations” is equal to a default. It’s not. These obligations are to contractors, vendors and more. The government has stated they will prioritize social security, medicare and other obligations that would truly hurt Americans and the economy if they weren’t paid on time.
If the debt ceiling is not raised, it still wouldn’t mean the U.S. would default. The U.S. Government brings in approximately $250 billion in tax revenue every month. The debt payment each month is approximately $30 billion every month. The monthly tax revenue is more than enough to cover the debt service. Certain payments would need to be prioritized and some institutions may not receive payments they usually receive, but again, this is not default. If it were, we’d technically be in default right now with the government shutdown and not paying “non-essential’ employees.
In September 2013 the government took in $239 billion in tax revenue while bond interest in fiscal 2013 totaled $224 billion. So the government took in more in one month than total debt service for the year. This does not bode well for those betting on a default.
Putting it All Together
Due to the reasons I have outlined above, I am not overly concerned about a default. One way or another, debt service will be paid on time and in full. We don’t need congress to raise the debt ceiling to pay off our debt. Even if we did need to raise the debt limit, the probability is low that congress would allow it to happen as it’s a losing proposition for everyone. And finally, we’ve never defaulted on our debt before and no one wants to be responsible for having it happen for the first time and no one wants to see the effect it would have on the markets and economy.
by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.
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