Barron's Cover
SATURDAY, JULY 30, 2011
A Fool's Battle
By KOPIN TAN
The ugly budget fight is spooking the markets. What a default or downgrade would mean for stocks, bonds and the economy.
As Barron's went to press on Friday, investors seemed to be clinging to the hope that the fractious U.S. Congress will work out a deal to raise America's debt ceiling from its current $14.3 trillion level by the Aug. 2 deadline. How else to explain why 10-year Treasuries were up last week. And while stocks fell 4%, they are still only 5% off their three-year high.
Late Friday, House Republicans passed a revised plan that is contingent on a constitutional amendment requiring balanced budgets. While it's doubtful that this bill will pass the Senate, perhaps Washington will still find a way to avoid default. But who knows?
The big issue in this foolish fight is government's chronic overspending. But the immediate concern is the debt-ceiling fix, which is being held hostage by ideologues on both sides of the aisle.
After all, the U.S. can cover the interest on its debt -- estimated at $225 billion for the whole year and a mere fraction of what it earns in taxes (see table). Fixing the debt ceiling lets us borrow enough to keep paying our bills, and staves off an immediate default. Unlike, say, Greece, the U.S. can more easily print money. "Our capacity to meet our debt obligations isn't really in question," says Jerry Webman, chief economist at OppenheimerFunds. "But our willingness to pay is."
Congress, as it has done before, also can extend its borrowing authority temporarily, which will buy time to get spending more in line with revenues, which is the real sticking point among lawmakers. Most important, a default is an entirely avoidable disaster that will raise the country's borrowing costs, tip us closer to recession, and advertise our policy paralysis at a time when the struggling economy needs all the help it can get.
Alas, even if we can avoid an immediate default, we may not be able to avoid a downgrade of our much-vaunted triple-A credit rating. That will require our government to come up with a credible federal budget that wrings out $3 trillion or more in savings over the next few years. As it is, left-wing Democrats, quite childishly, are hesitant to cut spending in any real way, and right-wing Tea Party Republicans, quite unrealistically, are refusing to consider any tax increases.
Without that compromise, we can't fix our budget gap. Government spending is likely to equal 25% of economic output this year, up from an average of 20% over the past few decades. Tax revenue, meanwhile, is lagging behind at 15% of economic output, down from an 18% long-term average. And unless we fix this, rating agencies probably will downgrade U.S. Treasury bonds from triple-A to double-A-plus some time over the next few months. Of course, a downgrade would come much sooner should we default on our debt.
A CREDIT-RATING DOWNGRADE by itself isn't a catastrophe for investors. Markets from Japan to Ireland have shrugged off their downgrades, since rating agencies aren't exactly telling the bond or stock markets anything they don't already know about a government's credit-worthiness.
The problem, however, lies in our economy's ability to withstand the belt-tightening needed to bring our fiscal house in order. Government largess helped drag our economy out of recession, but as the artificial recovery enters its third year, economic growth has slowed to 1.3%, while unemployment lingers at 9.2%. The Commerce Department estimates that spending cuts at federal, state and local levels subtracted 1.2 percentage points from GDP growth earlier this year, a big drag. U.S. economic data this summer are falling short of forecasts, just as Europe is fixing a debt crisis and China is tightening credit. Against this backdrop, a loud public show of fiscal retrenchment can weigh on wavering consumer sentiment and persuade corporations to put off hiring or spending.
It helps that stock-market valuations are hardly stretched. Average investors are not overcommitted to stocks, having pulled $43 billion from U.S. stock mutual funds since late April as they steered nearly $50 billion toward bond funds. Profits at U.S. corporations remain strong. Yet "the stock market seems to believe economic weakness is temporary and set to reverse, which means there's risk to current equity prices if this proves not to be the case," says Michael Darda, MKM Partners' chief economist and market strategist.
Darda expects stocks to outperform Treasuries, corporate bonds and commodities in the long run. But over the next three to nine months, he urges caution and the conservation of buying power. "With stocks on the doorstep of year highs amid this gathering storm, you want to have cash you can put to work if the S&P pulls back 15% or 20%."
UNTHINKABLE THOUGH IT IS, each passing month without a debt-ceiling extension, which would require the government to immediately cut spending, could shave a half percentage point off GDP growth, and trigger a stock-market correction of 10% to 15%, says Credit Suisse global strategist Andrew Garthwaite. An actual default -- like a missed coupon payment on the $29 billion coming due on Aug. 15 -- would be catastrophic and could trigger defaults by other countries, a bigger decline in GDP and a 30% equity correction.
In contrast, a credit-rating downgrade carries less immediate impact. Most Wall Street firms expect forced selling of Treasuries to be limited, since mandates requiring fund managers to hold Treasuries typically don't specify triple-A ratings. Terry Belton, JPMorgan's global head of fixed-income strategy, says a downgrade would add no more than 0.05 to 0.10 percentage points to Treasury yields in the immediate aftermath. In a recent survey of asset-manager clients, the firm found less than 5% that would be required to sell some U.S. Treasuries in a downgrade. The U.S. also guarantees more than half of the planet's triple-A-rated bonds, but only 13% said they'll need to sell a modest amount of corporate or agency securities. JPMorgan also looked at nine instances over the past two decades when triple-A sovereign credits were downgraded. A week later, 10-year rates were up a mere 0.02 of a percentage point on average.
Over time, however, investors likely will demand a greater risk premium from a government that has allowed its fiscal health to slide from triple-A to double-A-plus. Belton estimates that benchmark Treasury yields could increase 0.6 of a percentage point. But ultimately rates will depend on Congress' plan for fixing our budget deficit. And fiscal uncertainty and government belt-tightening will weigh on growth and inflation expectations, keeping a lid on rates.
Mark Grant, head of structured finance and corporate syndication at Southwest Securities, thinks the 10-year U.S. yield near 2.80% might eventually fall below the German bund yield, now at 2.54%. At about 3.4%, Germany's economy is growing faster than the U.S., and it has a smaller budget deficit. But leading the bailout of its feckless neighbors could prove expensive. Resolving America's budget mess will boost the U.S., of course, and so would "the dawning realization that Germany is on the hook for 27% of all the funding" for a European crisis that's nowhere near resolved, Grant says. On top of that, Spain and Italy account for 30% of Europe's stabilization fund. But "if either one of these two countries needs to be bailed out, you may add their share of the burden right back to Germany and France."
Last week, economically sensitive sectors fell hardest, with declines of 5.8% for industrials and 4.9% for materials. (Telecom and utilities fell the least.) The dollar slipped against the euro, but further damage should be limited as bond yields in Italy and Spain near decade highs. In contrast, "the flight into smaller, safe AAA destinations is likely to continue," says Jens Nordvig, Nomura Securities' currency strategist. He flags the Swiss Franc, Canadian dollar, Australian dollar, Swedish Krona and Norwegian Krone as likely beneficiaries.
Gold, at a record $1,628 per troy ounce, is up 14.6% this year. Its ascent could slow with some resolution in Washington. But ultimately gold "follows the path of the U.S. debt limit and U.S. debt outstanding," notes Larry Jeddeloh, chief investment officer of TIS Group. And both seem headed higher.
WILL INVESTORS OVERREACT to a debt downgrade with a knee-jerk dumping of dollar assets? Douglas Cliggott, Credit Suisse's U.S. equity strategist, thinks a ratings cut is already well-anticipated by the market. In fact, "the stock market's frustratingly low price-to-earnings multiple is a recognition that the current government-debt status quo isn't sustainable," he says.
The Standard & Poor's 500 closed Friday at 1292, roughly 14.4 times the $90 in operating profits companies earned over the past year. That's already below the market's median multiple of 16.9 times over the past decade. Cliggott thinks a U.S. debt downgrade could drive the P/E down to about 13 times profits, which would put the index near 1200, before bargain hunters are drawn by the relative value of big, blue-chip U.S. stocks with strong balance sheets.
With the world's most liquid risk-free financial instrument set to lose its exalted rating, Myles Zyblock, RBC Capital Markets' chief institutional strategist, flagged at least four S&P 500 companies that boast triple-A ratings and pay yields of at least 2.2%. They're Automatic Data Processing (ticker: ADP), ExxonMobil (XOM), Johnson & Johnson (JNJ) and Microsoft (MSFT).
JPMorgan equity strategist Thomas Lee recently screened for stocks with superior credit to Uncle Sam, which he dubs "the new sovereigns." They include Texas Instruments (TXN), Amgen (AMGN), Merck (MRK), UPS (UPS) and Oracle (ORCL).
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