Fund managers scrutinize default dilemma

If the worst comes to pass – the U.S. goes into technical default on its debt – there’s no telling what the market reaction will be. The bottom could fall out, creating a massive buying opportunity.

As it comes down to the short strokes, however, fund managers in Canada seem sure the political brinkmanship will make way for some form of relief by or before the deadline. And if there is an outside chance of panic selling triggered by the U.S. default, they said, the buying opportunity will be too short lived to be of any consequence.

“If there’s a knee-jerk reaction next week the markets will likely bounce back as soon as they get a sense that politicians are going to move forward and stop posturing and bickering,” said David Stonehouse, director, fixed income and portfolio manager, Acuity Investment Management Inc.

The situation, said money managers, doesn’t warrant building up cash reserves in advance of a probable buy signal. Stonehouse for one is not making any portfolio adjustments.

“The sense that I have is that most people are not building up huge amounts of cash in anticipation of a U.S. debt default in particular,” he said. “We haven’t made a material adjustment to the portfolio’s holdings in advance of August 2.”

Sentiments expressed by David L Fingold, lead portfolio manager of the Dynamic Global Discovery Fund, are pretty much the same. He said building cash reserves in anticipation of the potential fallout of the debt crisis is like making similar preparations around “Y2K, the killer bees, the swine flu or a killer asteroid that’s coming to destroy the earth.”

“I think that the idea of mass panic and sell-offs just sounds like overkill,” he added.

That is not to say Fingold doesn’t have a plan up his sleeve in the event the worse case scenario does happen. “We have an all-cap portfolio [with] a lot of liquid large caps; if there were opportunities created in small caps we could step up to them, we have a position in precious metals bullion [which is] highly liquid [and] we can use it,” he said.

The most damage, said Fingold, will be done to the banks and insurance companies, of which he owns none. That being said, the debt ceiling is one of the “smaller problems” the world is dealing with today, he said. “I don’t think we’ve ever had a crisis that hasn’t been presaged by a significant move in credit spreads [and on this occasion] credit spreads haven’t moved.”

Stonehouse largely puts the whole issue down to political shadow boxing before some negotiated resolution. “Clearly what we’re dealing with, notwithstanding each party’s claim to be acting for the greater good of the country or the economy, is a lot of political posturing and neither party has shown that much willingness to relinquish their cherished views and tried to come up with a compromise and a negotiated middle ground with their counterpart.”

While August 2 is deemed to be the hard and fast deadline, the reality is there’s a little bit of wiggle room to manoeuver. “What it is going to come down to is whether or not at that point the U.S. can demonstrate that it can still meet its payments in the short term,” said Stonehouse.

No one expects the probability of a default to be particularly high. “It is more of a ‘technical default’ in that if they were not to raise the debt ceiling in time they wouldn’t be able to make their daily or weekly payments on a temporary basis,” said Stonehouse. “There is a difference between a temporary miss in making whatever payments you’re obliged to make and the underlying fundamental creditworthiness of the country.”

Fingold too thinks things will fall into place and it will all end uneventfully. “Nothing is going to happen,” he said. “No one is suggesting that the government not cut a single cheque and part of the problem is that, technically, the treasury department has no ability to cut some cheques and not others.”

Fingold expects there to be, at the very least, a temporary extension of the debt ceiling “because no politician wants to face an electorate that didn’t receive a social security cheque.”