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Monday Market Calls | The Federal Debt Ceiling and Treasuries
Call #1: Underweight Long-Term Treasuries
The federal government is limited by law as to the total amount of debt it can issue. This limit is known as the debt ceiling. Currently the debt ceiling is 14.3 trillion, an amount that was technically exceeded last Monday. Fortunately, the government can continue to operate and pay its obligations through various accounting mechanisms. Treasury Secretary Geithner has suggested these mechanisms will allow the government to continue to function and avoid defaulting on its existing debt through early August, after which point the government could theoretically default on its Treasury obligations, something that has never happened in US history and would obviously be catastrophic for financial markets.
Most analysts, ourselves included, do not believe this will happen. Instead, similar to the 2011 budget deal earlier this spring, there will be a lot of political drama and the issue will likely go down to the wire. Still, we do believe Congress will raise the debt ceiling before the deadline.
The issue that’s holding up what is normally a fairly routine and non-controversial process is a mostly Republican insistence that any rise in the debt ceiling be accompanied by significant spending cuts and long-term deficit reduction. Not surprisingly, there is little agreement between the two parties on how to go about this. There was some hope in the Senate based on a plan by a small group of bipartisan senators, known as the 'Gang of Six'. Unfortunately, it looks like those efforts recently collapsed over differences regarding Medicare reform.
Despite the collapse of the Gang of Six's initiative, we believe a compromise will be reached in time to avoid any government default, but similar to the 2011 budget deal the compromise will be largely smoke and mirrors and contain little in the way of real deficit reduction. Real deficit reduction will likely have to wait until after the 2012 election, and even then will happen only if the election produces some type of consensus on how to tackle government spending and taxes, which at this point appears unlikely.
The investment implications of all this are twofold. First, in the short term, we believe fears of a default are exaggerated, and thus we do not think the debt ceiling issue represents a significant short-term risk for the Treasury market.
Longer term, the conclusion is the opposite. With the likely end to negotiations over the debt ceiling likely to be something similar to the 2011 budget deal, we believe the continuing inability of Washington to enact real fiscal reform means that large deficit spending is likely to continue over the intermediate term and with it, there is likely to be a continuation of the large supply of Treasury notes and bonds. This supply occurs against a backdrop in which the real, or inflation adjusted yield, on the 10-year US Treasury is around 70 bps, roughly one quarter of the 60-year average. In other words, at a time when deficits will likely ensure record supplies of new Treasury instruments, the price of longer dated Treasury instruments is at a record high. As such, we continue to believe the US Treasury market offers little value and would remain underweight TLT and other long-term Treasury funds over the long-term.
Potential iShares solutions
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Monday Market Calls: Europe and Volatility
The upshot of all this is while we believe the euro zone will continue to recover along with the global economy, European stocks – particularly the banks – are likely to trade at a discount given the lingering concerns over sovereign debt. The exception to this remains the northern European countries, particularly Germany, whose economic strength is compensating for the risks at the periphery. Despite the troubles in Greece, we still favor Germany.
Call #2: Overweight Healthcare, Underweight Small Caps
Our basic view is that while the US market can continue higher, the gains are likely to be accompanied by more volatility than we witnessed during the first 4 months of 2011. With the exception of the spike around the time of the Japanese earthquake, US market volatility has been its lowest since 2007, with the VIX Index – which measures implied volatility on S&P 500 options – hitting a four year low of below 15 in April.
We believe this is too low. Over the past 20 years volatility on US large cap stocks has averaged around 20% a year. Given the current environment, which is characterized by the continuing unrest in the Middle East, the lingering US sovereign debt issues, and the lingering European sovereign debt issues, it is hard to justify below average volatility. On a more quantitative basis – we can model the volatility based on a number of factors including market momentum, credit conditions, and changes in leading economic indicators. When we compare the current level of volatility to these indicators, market volatility looks around 25% too cheap. In other words, we believe that market volatility should be in the low 20’s not the mid teens.
Bottom line: volatility looks set to rise further this summer. We favor the following: (1) lower portfolio beta through more defensive sectors like Healthcare and (2) lower exposure to small caps, which tend to be more volatile.
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Source: Bloomberg
Disclosure: Author is long EWG.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country, investments in smaller companies and narrowly focused investments may be subject to higher volatility.
The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Dow Jones Trademark Holdings, LLC, MSCI Inc. or Standard & Poor’s. None of these companies make any representation regarding the advisability of investing in the Funds. Neither SEI, nor BlackRock Institutional Trust Company, N.A., nor any of their affiliates, are affiliated with the companies listed above.
iShares Blog
The news in Europe continues to be mixed. On the plus side, the core countries in Europe continue to post strong economic growth. We had more evidence of that this week with solid GDP results from both Germany and France. The problem of course remains the periphery, particularly Greece. Greek debt was downgraded again and markets are now convinced that Greece will need to restructure – the lingering question is when and how. The when refers to the fact that originally Greece was expected to return to the bond market in 2012. That now looks highly unlikely, so Greece will need another 25-30 billion Euros from the European Union to fund their deficit next year. The how refers to the fact that a restructuring by Greece could take many forms, the most benign of which would be a “re-profiling”, or extension of the maturity of the existing debt. This may not be enough, so Greece may need to ultimately have a managed restructuring of its debt, with bondholders taking at least a 25% haircut on their holdings.
Monday Market Calls | 3.28.2011
Call #1: Underweight European banks
As Europe continues to muddle along, much of the bad news has been discounted in with the exception of the banks, which are likely to continue to remain under pressure.
S&P cut Portugal’s rating two notches as its parliament rejected the government’s new austerity measures, prompting Prime Minister Jose Socrates to resign. Meanwhile Moody’s downgraded 30 small Spanish banks with mostly negative outlook following the earlier sovereign debt rating downgrade. However, despite the banking issues, Spain has been able to continue financing its debts.
In last week’s summit officials agreed to increase the European Financial Stability Facility (EFSF) fund to 440B EUR by June. As long as Spain can continue to fund its government, the EFSF can finance a Portugal bailout. This is a major negative for European banks, which are the holders of sovereign debt and will ultimately need to raise more capital, diluting existing shareholders.
Call #2: Overweight global energy
Late last year we listed the energy sector as a likely leader in 2011. Year-to-date the U.S. energy sector is up 15%, while the global energy sector is up 13%. We believe that ongoing geopolitical risk will keep oil prices elevated. While energy stocks do not look as cheap as they were earlier in the year, they are still trading at or below market levels. Of the two (U.S. and global), we favor global energy companies as they are a bit cheaper.
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Source: Bloomberg
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The iShares Funds are not sponsored, endorsed, issued, sold or promoted by MSCI Inc. or Standard & Poor’s. Neither of these companies makes any representation regarding the advisability of investing in the Funds. Neither SEI, nor BlackRock are affiliated with the companies listed above
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.
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