Debt Fight at the (not so) O.K. Corral

October 16, 2013

Boasting  an impressive return of 19.66% through September, this year's stock market has already surpassed every calendar year since the 1990s (except 2003 and 2009, which were recovery years following major bear markets.)

This  is no small feat, considering:

1) We’re no longer at notably low valuations. 

2) The monetary stimulus, put in place during the deep recession, probably won’t last much longer.

3) There are no big fiscal plans on the horizon. 

4) Investors are actually pretty fearful. Recently, we've seen several billion dollars exiting U.S. stock funds each week. 

 5) Politicians appear to be willing to take the government and the economy to the precipice in order to further their own political goals. 

Let’s focus on this last issue and its implications for investors. Hopefully, the problem will have resolved itself politely by the time you read this.

Without getting into the finer details of the government shutdown and potential debt default (which are somewhat separate issues,) let's agree that the government can cause economic problems, both real and imagined. 

The economy and markets are heavily influenced by purely psychological factors. People spend or invest based on fear, optimism, and expectations for the future. Consumers and investors make decisions based on tangible factors like wage growth and tax rate changes, but they're also surprisingly motivated by fluctuating optimism. It's entirely possible that most booms and busts are largely caused by swinging collective expectations.

Perhaps one reason this year's tax increases, like the ones in the 1990s, had less of a negative drag on the economy is this: although they reduced spending power, they were offset by increases in optimism. Thanks to a slowly improving economy, housing market, and stock market, things have been looking up. 

Investors are even more prone to moodiness than consumers. It doesn’t take much to rattle optimism. This year, before the political winds began blowing anew, the big fears lay in the bond market, not the stock market. The concern was that interest rates wouldn’t stay low much longer, because the improving economy would make the Federal Reserve stop buying bonds with newly created money each month and halt other steps taken to keep all sorts of interest rates, notably rates on home loans, low.

This led to an abrupt rise in rates that hurt most yield-oriented investments. Money flowed out of bond funds, notably municipal bond funds, and discounts widened for closed-end bond funds. This move was all about interest rates going up. There were no growing fears of default like we saw in 2007-2008 when higher credit risk bonds fell in some cases as much or even more than stocks. 

We used the 2008 slide to up our higher-credit-risk bond stakes, and this most recent fall to increase our longer-term, investment-grade bond positions in our model portfolios.

Investor fear of rising rates recently waned as it was replaced by a fear of global collapse caused by an insolvent U.S. government. In fact, interest rates went back down somewhat. How exactly a debt default would play out is impossible to know, largely because it's so difficult to predict how investors would react if it occurred.

So far, the investments most "at-risk," U.S. government bonds, have performed quite well, although credit default swaps (insurance against U.S. default) have become more costly). Very short-term debt in the form of Treasury bills was the only area in which jitters were apparent. Recently, one-month Treasury debt was trading at a slightly higher yield than three-month debt.  Insurance (in the form of put options) against stock market slides has become more expensive.

Debt defaults are probably the leading cause of both bond and stock market crashes, and can certainly cause recessions. Lenders – banks or bond investors – are understandably fearful. They're looking to get paid back and earn a relatively small return for the risk they take of not being paid back. Stock investors expect more risk.

Much of the real estate-led economic slide of recent years was the result of rising default rates on debt backed by real estate. This led to a huge decrease in lending as the perception of the risk of repayment was high. Most emerging market slides accelerate with a few companies defaulting, or in the case of the 1990s, Russia defaulting on some government debt. One of the reasons behind the boom of the last decade or so in emerging markets has been the perception that defaults are low and going to stay low.

U.S. government debt sits at the very top of the global pyramid of investing. It's the foundation of all investing risks and returns. No one really knows what would happen if we experienced even a temporary default. The largest lenders to the U.S. – Japan, China, and large investment funds – probably know that even if a default actually occurred, it would be short-lived, and they’d get their money back soon enough. This is very different than what we saw in countries like Greece that couldn’t afford to make payments at all. We can make payments close to forever, and could probably do so even with significantly higher debt loads than we have today. 

But the psychological damage a default could cause is potentially high. There are too many unknown knock-on effects. What happens to the mortgage market in the event of a default? After all, mortgage rates are set by government rates. What about FDIC insurance? Could we have a run as investors panic about coverage guarantees? Are banks in financial trouble (again) if they have to start paying investors 4% on CDs shortly after making lots of auto loans at 3%? What about stable value funds that own government debt? Will 401(k) investors panic-sell them if they see a price slip? What about money market funds that own short-term government debt?

Our best guess is nothing will happen. We’ll get some kick-the-can-down-the-road solution (or at least a financial hat trick to buy time), and the market will actually go up as investors who've been "waiting for this to be over" jump in and those that are short the market close out their positions. We may have already seen some of that last week on the big 300+ day for the Dow. But that's just a guess. And that’s the scary part.