Government Drama and Market Decisions

10/17/13

Many of you have asked what we think about the government shutdown and a possible default by the United States on it’s debt so we wanted to send out a quick note on that.  Of course, a last minute deal last night has temporarily put an end to this topic, but it is likely to reappear in a few months and many more times in the future, so we’ll discuss it anyway.  Let’s quickly summarize the issues without getting into the politics:

  • Per the constitution, Congress must pass the fiscal Federal Budget for the fiscal federal year of Oct 1 – Sept 30 each year.  This is achieved when the House and Senate come to an agreed upon budget and send it to the president for his signature or veto.
  • As of October 1st, the Senate and the House of Representatives were not able to agree on and pass a budget for the upcoming year and as a result, the Federal government began a partial shutdown.
  • The United States has a Debt Ceiling, which limits how much money the Federal Government can borrow.  Once the debt limit is hit, the treasury can take “extraordinary measures” to fund operations, which is basically an emergency fund.  We are using those funds now, and they could run out as early as October 17th, though some analysts believe that could extend into November.

Both the shutdown and the debt ceiling could have a negative impact on our economy and the longer they last, the bigger the impact.  But the one that could potentially have the biggest impact on the stock market is the Debt Ceiling.  If the government cannot pay it’s bills, then they could end up defaulting on their debt (or US government bonds).

So, what are the chances that the government defaults on its debt eventually?  Many have said that they think the chances are fairly high given the rhetoric out of Washington DC.  But others like Warren Buffet and Bill Gross of PIMCO (the largest bond fund management company) don’t think so.  Buffet has said that he believes the “idiocy in Washington” will take us to the brink of default but we will not default.  And Bill Gross said that he believes the odds are a million to one that the U.S. will not default on its debt.

We tend to agree with this viewpoint.  United States Bonds have enjoyed the unofficial status of being the “safest place in the world to put your money” for many years.  However, that status could change and should not be taken for granted.  It was interesting in 2011 to observe what happened when Standard & Poor’s lowered their rating on US Bonds from AAA to AA+.  It was widely believed that if and when the rating was lowered, it would have a negative effect on the interest rates of US Bonds – in other words the interest rates on the bonds would go up because investors would be inclined to sell US bonds until the interest rate were higher to compensate for the lower rating.

But when Standard & Poors lowered the rating from AAA to AA+, there was a bit of panic in the air and the stock markets sold off and there was a “flight to safety” – meaning that nervous investors were selling riskier assets and buying assets that they considered to be safer.  And as it turned out, for many investors that meant buying US treasury bonds, which resulted in interest rates on US bonds going down, not up.  What an unexpected benefit from a negative event – the interest expense for US bonds actually went down after being downgraded…very unusual, but a fortunate benefit of being considered “the safest place in the world to put your money”.

So, why would we want to take any chance of jeopardizing that status?  Maybe we can get away with another downgrade, or get away with skipping a couple of interest payments just to prove a point.  But why risk it?  We do need to reduce our annual national deficit, but because we have so much debt, we absolutely need to maintain our “safest investment” status with investors as that keeps the rate of interest that we pay on the debt as low as possible.  Today, most investors believe that when they buy US bonds there is virtually no chance that they won’t get their money back – they trust the US 100%.  And if we do something stupid to jeopardize that trust, then the US could gradually see their debt interest expense go up much higher than it should be.

In the words of Warren Buffett, “to even play around with the idea of the United States damaging it’s credit worthiness is unthinkable and should be banned from the arsenal of both parties (Democrats & Republicans) and should never be on the table”.  Buffett goes on to suggest that we eliminate the debt ceiling and not take any chances with our credit worthiness in the future.

We have been grappling with these issues in recent weeks and the idea of whether or not to sell some investments to raise more cash and reduce risk.  To this point we have decided not to sell anything as we have felt like we have “seen this movie before” and congress never seems to get anything done until the last minute.  And as of last night (October 16th), it appears that congress did pass a bill to reopen the government and raise the debt ceiling enough to get us through the next few months (February 7th or so).  Hopefully we won’t have to go thru this again in a few months and with any luck, maybe congress will get rid of or modify the debt ceiling but we won’t hold our breath as they will most likely put together another last minute deal to extend the debt ceiling another few months to a year. In other words, you may see this update again on February 6th.