Our Thoughts

Debt Ceiling, Downgrade and Default

If you read, listen to, or watch the mainstream media, you get the impression that 1) not raising the debt ceiling, 2) a possible U.S.default on its obligations, and 3) the downgrade of U.S. Treasury securities are creating a perfect financial storm that will bring the U.S.economy to its knees. Although these three issues are related, they are very different with distinct consequences and solutions.

The most damaging issue of the three, default on the debt is extremely unlikely; the government has billions of dollars coming into the Treasury every month to meet its obligations and can use these funds to make bondholder interest and principal payments. The U.S. Government’s problem is not a revenue problem, it’s a spending problem. Something would have to be cut if the government runs out of money, but an actual default on the debt is highly unlikely.

A downgrade of the debt by one or more of the leading ratings agencies (Fitch, Moody’s and S&P) is a very real possibility whether the debt ceiling is raised or not.  Although certainly not a desirable outcome, it need not be catastrophic. For long-term implications look at Japan—its debt was downgraded to AA in 2002, and then downgraded again in January of 2011 to AA-. The Japanese economy, although not as strong as it once was, has not collapsed. The people there still eat and function as a developed society and the Yen is still one of the world’s reserve currencies. A downgrade to AA is a long way from a CCC rating like Greece.

Even if the rating was cut U.S. Treasuries would still be the preferred currency for many domestic and foreign investors. Why? $13.4 trillion worth of Treasuries are held domestically and those investors would most likely opt to keep their investments at home. A mass liquidation by foreign holders—primarily central banks—would adversely affect the value of their remaining bond holdings, so it would be very foolish of them to start panic selling. Given the global economic situation, no other world currency offers the stability or liquidity of U.S. Treasuries; there just aren’t any other alternatives at this point.

As far as the long term investor  is concerned, there are actually many positive things going on in the financial world. First, corporations, U.S. included, are some of the strongest institutions in the world (Apple has enough cash in the bank to practically solve the Greece crisis itself). Also, manufacturing and industrial companies worldwide, once again U.S. included, have been expanding quite well the past two years. Additionally retail sales continue to trend upwards, defying expectations. Finally, despite higher food and gas prices, true inflation (defined as a broad systemic rise in the price level of an economy) remains low. All these are at least somewhat positive even for the most pessimistic souls.

We believe Democrats and Republicans understand the negative short-term consequences of not raising the debt ceiling and that some sort of deal will be struck. What kind of long-term plan they come up with to fully address the economic issues facing the country is anybody’s guess. But a default on U.S. Treasury debt remains unlikely as does a catastrophic ratings downgrade. And, despite its sluggishness, the United States has a resilient, broad-based economy that will continue to grow.

We remain vigilant and in tune with the changing situation but simply don’t feel the need to panic. As I have said many times through the years, all of the employees of D.L. Blain & Co. and their families are invested in exactly the same things as clients. I am personally adding funds to my account this week so that I can purchase more stocks if investors start to panic.

The situation in which we find ourselves today illustrates perfectly why we construct global, broadly diversified portfolios for you, our clients. Please don’t hesitate to call or email if you would like to discuss this further.