Every day, it seems the debates over the debt ceiling and associated fiscal problems faced by the United States are taking precedence in the news. Politics at its worst has been on display in this latest round of meddling into the financial markets.
At risk is the credibility of the United States as a borrower, but there are also potential liquidity risks as the issue is much deeper than a simple potential for default. In today's world fraught with panic and fear, it is important to understand your cash investment strategy and ensure your approach is right for you.
At SVB Asset Management, we focus on corporate cash investors who primarily are interested in preserving their capital and liquidity over achieving outsized returns. Historically, in times of stress, the cash markets have typically been left unscathed. But in recent years, they have been tested for both valuation and liquidity. Since the 2008 liquidity crisis, we've held higher portions of our portfolios in government securities — believing market risks have remained significant as the economy continues to struggle.
Now, with the challenges the government is facing on the debt ceiling, even government securities are highly scrutinized. It is our opinion that all U.S. government backed investments will remain liquid and pay on time and in full. As a result, we are very comfortable with the positioning of our portfolios and do not see the need to adjust our investment strategy at this time.
Background on the Debt Ceiling
Contrary to what popular media may have you believe, the debt ceiling has been around since 1917 and has been raised 77 times, starting at $43 billion and currently residing at $14.294 trillion. In fact, Congress has raised the roof 10 times this century and three times since President Obama took office.
It is a regular course of events to raise the debt ceiling in Congress.
Consider the fact that in order to make good on our obligations, we need only print money. This is the famed money-tree that our parents always said didn’t exist. There is certainly some downside to printing money — specifically, inflationary pressures must follow as more dollars chasing the same number of goods equals higher prices. But we're not generally suffering higher prices today given such a sluggish economy.
It should be noted this situation is much different than in Europe. Here, we are arguing about our will to pay. There, they are struggling with their ability to pay.
What Will Congress and the President Do?
There are effectively three possible scenarios, listed below in order of likelihood:
1. Resolution
We at SVB Asset Management have felt for several weeks that negotiations would come down to the 11th hour, but that an agreement will be reached and a default avoided.
This does not mean the government will retain its pristine AAA rating, as both Moody's and S&P have inferred a possible downgrade depending on the outlook for America’s fiscal health. And even if the AAA rating is retained, it's possible the damage to our reputation has been done and other safe haven investment strategies will appear in the future to complement a Treasury-only approach — though none that offer equivalent safety and liquidity come to mind at the moment.
In any case, this is obviously the preferred scenario, and from our point of view, it is the most likely one, too.
2. Kick the Can
In this scenario, a temporary lifting of the ceiling is achieved with a short time frame to come to agreement on budgetary concerns.
Here, the possibility of a downgrade increases but the possibility of default is eliminated. Unfortunately, the debt ceiling continues to gain headlines and the potential for fear to tip over into action increases. Just what that action might be is questionable.
This scenario is also a solid possibility and is not all bad news for the markets. Though a full resolution is preferred, the markets likely will take this delay as a way to achieve a full resolution in the near future.
3. No Resolution in the Near Term
Under this scenario, the Treasury has several options that do not affect principal and interest payments on Treasury securities. We believe the Treasury will exhaust them all before actually defaulting on any obligations.
These options are so unpalatable that they likely will drive Washington to react with a solution tout de suite. The option most likely to garner headlines is to delay social security payments, which will create an outcry among voters violent enough to prompt a quick shift to either option one or two above.
At no time do we believe a default on Treasury securities is a realistic scenario to consider.
It should be noted that many believe this "drop dead" date to be August 2, but according to a few Wall Street research shops, higher tax receipts in recent months may push this date back a week or two.
What do the Markets Believe?
In what may seem a bit counterintuitive, the markets seem be telling us that if a debt ceiling should not be raised and government spending is cut back drastically, as in scenario three, Treasury bonds are the place to be.
How could this be?
The logic among market prognosticators is that if you a) assume the Treasury will pay interest and principal before anything else due to the tremendous damage a default would have and b) believe cutting back on all other spending would send the economy into a tailspin, then you must believe owning zero credit risk Treasury bonds is the right strategy.
Strangely, Treasuries and the yield curve win if Washington fails to raise the debt ceiling.
What Should We Do?
Given the scenarios outlined above, we do not feel we are at additional risk of losing principal or liquidity as we near a resolution on the debt ceiling.
Scenarios one and two above, which we see as the only possible solutions for any length of time, play well into our current investment strategies. Having said this, we are certainly cognizant of the effort our clients put into monitoring their investments.
As part of our advice since 2008, we continue to believe clients should consider the realities of their communications with their board members and other constituents when setting your investment strategy. Make sure your strategy allows for peace of mind among your constituents so that you can better use your time wisely managing your business.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value.