Government "Shutdown" Memo
Inquiring Minds Want to Know...
Q. I'm curious to know FAI’s thinking on the prospect of market gyrations around the current Government “Shutdown” and any potential Government “Default” on its debt payments. Are these risks that require any defensive portfolio adjustments?
A. These questions are doubtless on many people’s minds. Let’s take the two issues separately. A partial shutdown is already in effect, furloughing 800,000 government employees. We’ve had 17 shutdowns since 1976, lasting from 1 day to 3 weeks (see chart below for the full history of stock market performance during this time period). Furloughed employees are typically paid retroactively, so a shutdown of a few weeks, while inconvenient, shouldn’t have much economic impact. The shutdown gave the stock market a case of the jitters this morning (DJIA off -½%) but the bond market is shrugging it off (Treasury prices are flat, suggesting steady demand). A default would be more disruptive of the financial status quo; but we doubt either party will risk getting the blame for damage to the nation’s credit standing.
The calm bond market indicates little institutional concern about default risk... we think that is appropriate. Our government needs to issue $700 billion of new debt and roll over several trillion dollars of maturing bonds in the next 12 months; a default would make the cost of debt service rise by $170 billion a year for each 1% increase in rates... what government is going to risk that unnecessarily?
If the fat-tail risk of default should actually occur, our portfolio posture is probably the most resilient anyone could construct for that situation... because the duration of our fixed income portfolio is about 2 years, which is quite defensive... and the reason for our defensiveness, is our expectation that interest rates generally are likely to creep upward over nearby years with or without any new insanity on the part of government. If a rate rise is triggered by a Treasury default, it will just accelerate our opportunity to lengthen our portfolio duration and lock in higher interest payments even sooner than we expected.
We think that a default would scare money out of the US stock market... and that, too, would eventually be good for our portfolios since we are underweight in US stocks (more for valuation reasons than economic concerns) and a big correction in stock prices caused by a Treasury default would give us an opportunity to own more great businesses at attractive prices.
Across our stock and bond portfolios we are conservatively postured for reasons having nothing to do with a risk of a government debt default... which we doubt will happen... but if it should, it would create buying opportunities in both asset classes sooner than we had hoped.
To read the complete memo and graph, please click on the link below.
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