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Debt-ceiling crisis and how to position your portfolio

By Michael Preiss

07 August, 2011

Aug 2 is the official deadline for the US debt ceiling. If the debt ceiling is not raised, the US could potentially default on some its debt obiligations and suffer a ratings downgrade.

Until recently, the real possibility of a US government default was almost always dismissed in the same way: Don't worry about it. If the world comes to an end, your portfolio's net worth will not matter anyway.

However, a US rating cut is now more likely and investors need to be prepared.

The management of risk and volatility is mission critical to successful investing in the world's financial markets as extreme events can derail even the strongest fundamentals. The investment climate of the next decade will be shaped by the political, economic and financial market trends in 2011.

The financial markets have not priced in inflation risk in the US debt markets, even though the Federal Reserve Bank under Ben Bernanke has engineered a US$2 trillion expansion in the central bank's balance sheet. All three credit ratings agencies have stated that the AAA ratings of the US are at risk because of the possibility of defaults on Treasury debt obligations should the debt cap not be raised.

We do not know whether there will actually be a default on Aug 2 even if Congress and the Obama Administration do not act before then. Treasury Secretary Timothy Geithner is said to be working on a plan to extend America's ability to make payments to some time beyond that date. An announcement is not likely to be done until the day of the deadline. Geithner does not want to give up whatever small negotiation edge he has. Similar to the Greek bailout, a last-minute solution is likely.

In the unlikely event that US lawmakers are unable to come to an agreement to raise the US debt ceiling by Aug 2, financial markets around the world could turn chaotic. Banks are taking precautionary measures like keeping extra cash and seeking increased credit limits from friendly counter parties in the global interbank markets.

US Treasury prices are used as a reference rate for most other credit markets.

Some US$4 trillion of Treasury debt, about 50% of all issuance, is used as collateral in futures, over-the-counter derivatives and repo market, a crucial source of short-term loans to the financial systems.

While everyone seems to be focused on the US, my understanding is that the US Treasury's "cash on hand" actually means that the real deadline is not Aug 2 as is widely held but mid-August. Also, the deadline for an actual debt default is in all likelihood still much further away. It is up to the US government which types of payment to make and I believe that bondholders will be the very last in line as the US government will want to avoid doing anything that risks its ability to borrow if the debt ceiling is indeed raised.

Longer-term investors might want to use the current market nervousness and ask themselves whether they have enough exposure in the asset classes below that will benefit from the US debt ceiling crisis.

Blue chip US equities with high dividends and cash balances

Large-cap quality US stocks like Apple, Pfizer, General Electric (GE), Caterpillar, McDonald's and AT&T could benefit from a US rating cut. These companies are cash rich and run global business. AT&T as a stock is a case in point. With a yield of 5.7%, it will not default on its dividend obigations. Neither will GE, which pays a yield of 3.1%. McDonald's not only pays a high dividend, it has bought back billions of dollars of its own shares in the last five years, which has had the effect of lifting the stock price. Each of these US companies has significant cash on hand. Each has strong earnings. There are at least a dozen public companies that meet these criteria. None of these has any chance of default or a suspension of their dividend payouts.

Gold

The ability of the US to raise money was once based on its massive gold holdings. President Richard Nixon changed all that when he took the US off the Bretton Woods Gold Standard. On Aug 15, 1971, the US unilaterally terminated convertibility of the dollar to gold. As a result, the Breton Woods system officially ended and the dollar became fully "fiat currency", backed by nothing but the promise of the US federal government. Nixon apparently proclaimed that the US dollar is our currency but your problem. Many central bankers, especially in emerging markets, seem to sympathise with this statement on the eve of the US debt-ceiling crisis.

Gold as an investment with limited supply means prices will rise as more people and institutions buy it as a "safe haven". That means the price of gold will probably go much higher than its current all-time record, maybe even double, as some analysts believe. Gold has risen from US$1,168 to US$1,600 over the last year. The short-term risk of gold is that its price could fall precipitously if there is a short-term solution to the debt disaster, the crisis in the EU and the slow global economy. The US may solve its debt problems but the other two economic problems that help pressure gold's advance will not change any time soon, fundamentally supporting gold prices.

Swiss francs

The balance sheet of Switzerland is among the best in the world. Switzerland is the private wealth capital of the world and billions of dollars have already poured into the Swiss franc this year. This has sent its value up from US$0.95 to US$1.24 in a year and from US$1.18 just a month ago. Investors have to worry that the value of the franc could fall if the logjam over the American budget is solved. Once again, the solution to the US debt problem is not a solution to the world's financial difficulties and the deficit problems in small EU nations. The Swiss franc will remain attractive to long-term investors.

Canadian dollar and assets

Canada, like Australia, has an economy that is based on hard assets, many of which will rise in value with commodities. Mining, minerals, oil and agriculture dominate the Canadian economy. Canada is still the top trading partner of the US. The nation is also English speaking for the most part and its corporate law is very close to that of America. More than other markets, Canada will benefit once more Americans start to diversify their assets.

Singapore dollar and assets

Singapore may be one of the safest markets for US investors who want international exposure in the event of trouble with US debt. Singapore has one of the strongest ratings in the world and the Singapore dollar, along with the Swiss franc, is increasingly being considered a "safe haven" currency. Its stock market and currency, however, are too small to absorb meaningful inflows.

Triple-A US corporate bonds

Besides buying equities, there is another way for investors to seek the safety of American companies with the strongest balance sheets. That alternative is to invest in the corporate debt of the last four US firms that still have AAA ratings of their own: Exxon Mobil, Johnson & Johnson, Microsoft Corp and Automatic Data Processing Inc. Microsoft's balance sheet, for example, is so strong that its borrowing costs are as low as those of the US government.

Short-term muddle-through long-term sustainable solutions are difficult and politically unpopular but the Americans will find a solution. The real Black Swan event on Wall Street will be if Obama and the Republicans hammer out a credible deficit deal, similar to what Cliton did in 1995/96. This could then trigger an epic rally in the dollar and a major sell-off in the Treasury bond market as rates rise.

It is a striking coincidence that ‘American' ends with ‘I can'

The American people will overcome their economic and debt issues and it does not pay to be too pessimistic. On the other hand, we cannot neglect to prepare our portfolios and position for the worstcase scenario. In the final analysis, preservation of capital favours the prepared mind.

Michael Preiss is an investment adviser