Looking Past the Debt Ceiling

For the last year I have taken a more top down approach to investing because of the extraordinary actions taken in both fiscal and monetary policy. My argument for this approach is that fundamental earnings are less meaningful to stock performance when the outlook for prices (ie. inflation vs. deflation) becomes more unstable. Both wild swings in fiscal policy from stimulative to austere and repetitive monetary stimulus challenge the firmness of my 5-10 year outlook.  

The game of chicken in DC likely ends with fiscal austerity, in my opinion. The only question is whether a partial shut down of the government occurs first. Both sides are calling for tighter spending, just in different areas. The Democrats would like to increase the tax rate on higher incomes to help reduce the deficit as well. Whether taxes are included or not, government spending likely declines. After the craziness, our fearless leaders likely drive home austerity measures similar to what the UK put in place lest year.

Assuming severe budget cuts occur, either due to a partial government shutdown or through the congressional appropriations process, the UK is a good leading indicator of economic growth. A slowing trend is fairly obvious due likely to the austerity measures taken. This suggests the stock market declines and longer-term treasury yields fall.

Secondly, to tackle the likely downgrade of U.S. debt from Aaa to Aa1 I look at Japan in 1998 when the country lost its Aaa rating. At the beginning of April 1998 Moody's changed its outlook on Japan debt to negative. The yield on the 10-year was almost 2% and then moved down to just over 1.4% by June. By October the yield was well below 1% as the Russian Financial Crisis unfolded beginning in August. In November Moody's performed the actual downgrade. After the actual downgrade yields increased to over 2% by January 1999.

A couple things to keep in mind that were different from the current situation in the U.S. The downgrade coincided with the debacle known as Long Term Capital Management that roiled the world markets. The downgrade also came at the end of a recession, as illustrated by a healthy recovery in the stock market from about 13,000 in October 1998 to almost 18,000 by mid-1999. It is also important to note that the downgrade was due to ''uncertainties and heightened risks over the long term arising from economic and policy weaknesses that have led to significant deterioration in the government's fiscal position."

My takeaway from Japan and the risk to treasury yields from a ratings downgrade is that yields tend to reflect fundamental economic. Downgrades by ratings agencies can cause short-term volatility but ultimately reflect the economic growth outlook.

So where does that put me? Over 60% of my IRA is invested in 30-year treasuries, and a further 15% is in cash, as I play the slowing economy and potential for deflation. In short, nervous. However, as I continue to run the scenarios through my head I reach the same conclusions:

(1) The probability of the U.S. missing a debt payment is very low and our ability to meet future debt obligations is among the best in the world. This combined with the liquid treasury market makes treasuries the likely on-going safe haven in an increasingly risky world.
(2) The issue is a political issue about two competing views about the future (see my earlier post on Democrats vs. Republicans).
(3) Austerity is very likely, which should cause slowing economic growth.
(4) Debt problems in Europe, slowing growth in China, and risk in Japan suggest there could be a "black swan" event in the near future that pushes investors to Treasuries.

So I may push my equity positions to more conservative waters, but I likely remain in Treasuries for now. That said, I'm watching price movements very closely to get some sense of how the market may react.