Special Commentary on the US Budget Crisis

You would have heard that US Congressional leaders in Washington have to date failed to reach an agreement on the US Budget Legislation. This resulted in the ‘Shutdown’ of various government services which we are now witnessing, and which will continue until a resolution is reached.

This is the 18th shutdown since 1976 but the first in over 17 years.  The ‘shutdown’ has affected some 800,000 public servants who are either not working or working without pay in various public service areas.  The longer this lasts the greater the ‘drag’ that will occur on the US Economy.  A range of economists have suggested that a downgrade to GDP of about 10 – 15 bps (0.01% – 0.15%) for the quarter could be the result.

The extent of the negative an impact is largely dependent on how long it lasts.

The major effect for markets is reducing consumer and business confidence.  Business and consumers might stop (or reduce) their spending and exacerbate the lack of government spending.

The other issue that is gaining media interest is the so called US ‘Debt Ceiling’.  This is a self-imposed $16.7 Trillion Credit Limit that congress agreed to, and can only be increased by passing through Congress.  It has been estimated that the US will hit this ceiling on 17th October.  However, the US Treasury predicts they will have some $30bn in cash to meet obligations, so dependent upon when obligations fall due, the 17th could stretch to the end of October.  Unfortunately, this would see extreme volatility in stock and bond markets.

Failure of the US to agree to raise the Debt Ceiling will in the short term lead to the US defaulting in the Bond Market, a truly catastrophic event with unimaginable financial consequences for the US and the world.

It is likely markets will become increasingly nervous about the debt ceiling as politicians are using the date as a way to position their own political agendas.  The main scenarios appear to be:

1.     accept a short term debt ceiling increase

2.     raise it for a year

3.     abolish it all together

4.     one of the 3 above, pursuant to political demands

5.     accept a US Government default

Only the most extreme commentator would suggest option 5, and most economists are predicting option 4.  President Obama felt he gave up a fair amount at the beginning of the year in relation to rising taxes and spending cuts, and currently believes he has the numbers that would see no need to negotiate.  The Speaker is not prepared to call a vote on this basis so there will be more negotiation.

Should the most extreme action occur, the US could redirect income to debt repayment that would not see a collapse in the bond market but would result is severe funding cuts.  This would have the potential to send the economy into recession or depression depending upon the severity of the cuts.

We believe that uncertainty brings opportunity. Any material fall in the stock markets will present buying opportunities as prices drift away from their year highs, but these opportunities should be considered in line with individual investor risk profiles.  In the longer term the key issue is the size of the US debt and how that is reduced as it will be a long term drag on economic growth and this effects investments not only in the US but all over the world.

It continues to be our view that we should focus on income from quality companies and remain wary of investments that rely on strong economic activity to drive revenue.