Downgrade or default. Let’s start there. A US sovereign downgrade won’t hurt the markets. Rating agencies are a few years late to the party and market participants have already devalued US$-denominated assets by 80% over the last 5 years. In English, an 80% decline in value is well within the meaning of the word “downgrade”. So a change in rating or outlook by the agencies is a friendly reminder and not a change in facts.
Default – not getting a debt limit deal done – is a different story all together. The US Treasury not paying its debts may mean your wealth changes by an order of magnitude and your ATM card stops working this week. You can see the first signs of this happening in the funding markets last week. To make sense of the funding markets – a quick explanation of the way these markets work in 50 words: there are trillions of dollars of assets at banks, mutual funds and companies – rather than moving these assets around constantly to do transactions or borrow money, which would be cumbersome, these institutions leave the assets alone and instead pledge the assets as collateral in exchange for cash to do whatever needs to be done day-to-day. Sort of like if you had a house, and needed to pay a $1,000 bill before payday – you wouldn’t sell the house to pay the bill, you’d just borrow $1,000 against the house until you got your pay check. This is called a “repurchase obligation” or “repo”. If there is no debt limit deal by Monday morning, the “repo markets” will be the news, here’s why.
This past week was an important time for the repo markets because non-bank financial institutions that usually borrow for 30 days had to do their borrowings by month end (Friday). 30 days from now means August 31st, so after the August 2nd debt ceiling deadline. This crunch at the end of every month usually pushes prices to borrow for 30 days up by .03%, but at the end of last week it moved out by .30%. This change in pricing was worse than during the financial crisis. Despite this shock, all was calm elsewhere in the markets on Friday because the big boys of the funding markets – banks – primarily borrow “overnight”, so their repo borrowings on Friday were mostly for August 1st, before the deadline. It’s not really clear what will happen on August 1st in the afternoon, when the world financial system tries to borrow trillions for August 2nd, pledging as collateral securities that may be in default the next day. These repo markets is what did in Lehman Brothers, Goldman Sachs, Citigroup and others during the financial crisis. If counterparties don’t really believe/like the collateral you are pledging, the game is up the next morning.
There is talk that the US can prioritize payments and pay its debts for a short while, but it’s hard to imagine this will be acceptable to the markets. Fixed income investors are often faulted for their lack of imagination, but they aren’t stupid. This is an old trick that every company in the deadzone – including Lehman – has tried. It’s not a slippery slope for a company that briefly stops paying its employees, it’s a cliff.
What will actually happen without a deal on Monday morning? The value of assets will probably decline throughout the day. A bit more cash will be found to push out the August 2nd deadline and a deal will get done because constituents’ savings will decline in value rapidly. With TARP in 2008, an intransigent House of Representatives voted it down – the stock market fell ~10% – and TARP was passed a week later. I’d expect replay.
Distant from the debt ceiling headlines, the economy is plodding along, but still at a stalling speed that is below expectations and certainly below projections that justify the current market P/E multiple. Technology companies are seeing orders moderate and valuation multiples are contracting. Industrial demand is ebbing across the board. And financial services firms continue to shrink in a low interest rate environment. There is no escaping the economic math that financial services and real estate are the largest contributors to US GDP by a wide margin - the 80/20 of the US economy. So it’s hard for other sectors to perform for an extended period of time without a recovery in the core of what our economy has become over the past 40 years. Of more than passing interest, the stock market remains at cyclical highs. Sigh.
