Debt Ceiling Impasse: A financial version of the Cuban Missile Crisis

Today I released a white paper summarizing my thoughts on the debt ceiling impasse that goes beyond the “will we/won’t we debate” and goes into the possible scenarios that this might resolve into. Within a week, one of these scenarios is likely to have taken place, but for now, here is where the uncertainties lie.

Here are the main scenarios and a summary of investment implications:

Scenarios

There are basically three possible scenarios for the debt impasse to play out. Even an 11th hour agreement is likely to have long-term impacts on US creditworthiness and the yields that lenders will demand for taking on US debt, with follow-on effects. The scenarios are:

•        A last minute budget/debt agreement saving the day
•        No agreement, but no default
•        No agreement, and the US defaults on some obligations

Summary

A more detailed analysis appears [in the full document], but the key takeaway is that virtually all scenarios are negative for US equities, with differences in degree only. The scenarios are mostly negative for commodities as well, with the exception of precious metals. A last-minute agreement will be helpful to fixed income markets in the short term but will ultimately be bearish as investors question whether debt ceiling brinksmanship has become a permanent part of the political landscape. In currencies, the scenarios are largely negative for the US Dollar, but in the disaster scenarios, many currencies will not hedge as much protection as one might think because some economies are so closely intertwined with the US that a default and subsequent economic collapse may take down other economies as well.

A silver lining is that required returns are likely to be attractive following a crisis, whereas there is relatively little upside to be lost by setting aside cash, compared to the downside risks of being overly exposed to all risky assets. The market does not appear to have “internalized” or “discounted” these possibilities, because there is not nearly the degree of panic that would be appropriate. And large institutions simply may not be able to adapt quickly enough to avoid being hit.

There are three major effects to consider in each scenario: a) the immediate effect on asset markets as investors panic, feel relief, and/or reallocate, b) the short-term effect of increased Treasury yields on all assets as investors slowly digest that they are more risky, and c) the longer term effects of a budget agreement and/or higher required rates of return on the macroeconomy and earnings.

A copy of the white paper is available here. I may post the full text in a future blog post.