U.S. debt fight may spook markets

Earlier this week the U.S. Treasury revised its estimate for when Washington will hit the $14.294 trillion statutory limit on government borrowing. The limit is now expected to be reached between April 15 and May 31, having previously been pegged at April 5 to May 31.

The announcement was accompanied by the usual dire warnings from Treasury secretary Timothy Geithner and U.S. Federal Reserve chairman Ben Bernanke, who said delays in raising the ceiling could lead to an economically catastrophic default.

While some modest budgetary agreements were reached on Capitol Hill this week, the debt ceiling issue will likely fuel all manner of political wrangling—if not a full-out brawl—in the weeks ahead.

But is it even plausible to suggest that lawmakers would push their disagreements to a point where the ceiling isn’t raised before the debt limit is reached?

Stephen Lingard, director of research, Franklin Templeton Multi-Asset Strategies and co-lead manager of the Quotential Program, says the ruckus over whether the debt ceiling will be increased is “a bit of a red herring.”

“They’ll extend the ceiling. In fact, since 1940 the debt ceiling has been lifted more than 70 times. If they didn’t raise it we’d be in so much trouble. I just can’t see policymakers making that kind of massive, devastating mistake,” he adds.

Lingard suggests, however, that it would be unwise to dismiss the issue out of hand. “It’s going to grab headlines, there’s going to be some political meandering and fights,” and the whole affair could “spook the market.”

“It may be coming at a time when there’s a little more sensitivity to fiscal profligacy globally. We obviously have a major situation over in Europe, which we think is far more concerning in the short term. Longer term, the trends in the U.S.—their borrowing and fiscal position—are definitely worrying. But I think it’s a longer term story. We won’t reach a riot point this year that causes yields to go up significantly as a result of any kind of actual or potential default,” Lingard explains, adding that down the road the U.S. would do well to establish and enforce a responsible fiscal policy approach.

Lingard suggests the strong signs of economic recovery we’re seeing this year probably don’t have a sustainable, long-term trajectory. “That doesn’t necessarily mean double-dip, but it could mean stunted growth, or anemic growth on an ongoing basis over the next few years,” Lingard says.

“But let’s say we do get a recovery—we get job growth, the consumer comes back and spends, and we get 3%-4% GDP growth. The U.S. needs to address their fiscal situation, given they are running a fiscal deficit of over a trillion dollars—or approximately 9% of GDP. This means they need to improve their fiscal balance by increasing revenue or decreasing expenditures or a combination of the two by more than a trillion dollars annually, which is pretty significant. With the economy recovering, you should be able to pull in more than you’re spending,” he adds.

Lingard goes on to suggest that if the U.S. does not make progress on their persistent deficits, they may end up in a situation much like the one the Europeans are now facing.

“The only thing artificially holding down U.S. interest rates is a lot of central banks in developing countries importing U.S. interest rate policy. It makes no investment sense for the Bank of China to be lending to the U.S. government for 30 years at 4%, and taking a loss on the currency. So why are they doing it?”

“They’re doing it,” Lingard explains, “because they need the U.S. to continue spending. They have a huge trade surplus with the U.S., and they need this—it’s a symbiotic relationship. They’re not doing it because they want to make a return on their money. They’re doing it because they want to keep their economy rolling, they want to keep social unrest at bay, they want to keep unemployment low. There’s a very non-investment reason why they’re investing in treasuries.”

The danger in all of this longer term, Lingard says, is if the U.S. moves into a recovery but doesn’t address their fiscal issues, and “in the meantime a lot of the eastern economies reorient themselves so that maybe they don’t rely on the U.S., and they have a domestic sector and trade partners in other parts of the world. Why would you then hold U.S. treasuries given their investment return outlook?”

In this environment Lingard says his portfolios are leaning more to the equity side. Within fixed income he suggests “sectors like corporate bonds, high yields, floating rate bonds, and even emerging market bonds whose budget situations are in better shape than in most developed markets. Those are areas that will have relatively better protection if rates do start to grind higher.”