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The Debt Ceiling Strategy

01/03/2013

As expected, D.C. policy makers passed legislation to avoid a fiscal drag of $600 billion due to the expiring Bush era tax cuts and pending automatic spending cuts. The Senate bill was voted in favor, 89 to 8, followed by a House vote of 257 to 167 voting yes. In the House, 85 Republicans and 172 Democrats voted yes while 151 Republicans and 16 Democrats voted no.

The S&P 500® Index (SPX) responded on the first trading day of 2013 with an outsized move higher of +2.5% to close at 1462.42. Was the move predicated on “fiscal cliff euphoria?” Possibly; however,  keep in mind, in each of the past five years, strong flows of capital into the SPX on the first trading day of the year presented similar moves higher as witnessed yesterday.

  • December 31, 2008 SPX Close 903.25 & January 2, 2009 SPX Close 931.80   +3.2%
  • December 31, 2009 SPX Close 1115.10 & January 4, 2010 SPX Close 1132.99 +1.6%
  • December 31, 2010 SPX Close 1257.64 & January 3, 2011 SPX Close 1271.87 +1.1%
  • December 30, 2011 SPX Close 1257.60 & January 3, 2012 SPX Close 1277.06 +1.5%
  • December 31, 2012 SPX Close 1426.19 & January 2, 2013 SPX Close 1462.42 +2.5%         

The political discourse surrounding the passage of the American Taxpayer Relief Act of 2012 is disturbing. All I will offer beyond the mathematical evidence of the ATRA is the reaction of Alan Simpson and Erskine Bowles, co-chairmen for President Obama’s deficit reduction commission, who released the following statement: “The deal approved today is truly a missed opportunity to do something big to reduce our long term fiscal problems.”

Enough said! Here is the simple ATRA math:

  • The potential year-over-year increase in tax revenue fell from +19.63% to +7.51%.
  • The potential year-over-year reduction in spending of -0.25% now increases 2013 spending +1.87%.
  • Instead of a potential reduction in the 2013 deficit, the ATRA will increase the 2013 deficit $300 billion.
  • The emergency unemployment compensation (EUC) benefits were extended for a year, a cost of $30 billion.
  • Capital gains and dividend tax rates increase from 15% to 20%.
  • Payroll tax cuts expire.
  • Medicare doc fix was extended for one year.
  • Estate tax thresholds changed from 2012’s 35% of the value above $5,120,000 to 40% of the value above $5,000,000.
  • The budget sequestration was delayed until March 1, 2013.
  • The U.S. Treasury formally reached the statutory debt limit of $16.394 trillion on December 31, 2012.
  • The ATRA did not include a provision to raise the debt ceiling which now becomes the market’s focus (Figures 1.1 & 1.2)

The Debt Ceiling Strategy

For most of the first quarter, investors will be looking toward the late February/early March date when the Treasury can no longer conduct its business with the current “extraordinary measures.” At that point, either the debt ceiling is raised or the government’s ability to make payments (outside of interest payments) contracts significantly. The president and House Republicans have already framed the debate in a very contentious fashion. In fact, without raising the debt ceiling by March 1, policy makers will place tax refund payments in jeopardy. I would expect Social Security, Medicare, and defense spending to continue under the characterization of essential payments.

While I do not expect a U.S. default, I do expect private sector spending caution to persist during the quarter. During the first quarter, frugality will prevail. That frugality has already presented itself in the performance of the consumer discretionary sector, which was removed from my recent quarterly commentary’s investment themes. I do, however, suggest continued favorability in consumer physical wellness.

Rating agencies have provided guidance on expectations of a potential debt ceiling debate similar to 2011. S&P already downgraded its long-term rating for the U.S. to AA+ back in August 2011. Moody’s & Fitch still rate the U.S. at AAA, so they would be most likely to downgrade the U.S. if they believed an actual default would occur. The outlook for all three rating agencies’ views on the U.S. is negative. I do not view any potential rating agency action as not reversible, or a rating that would be negatively attached to the U.S. for an extended length of time.

  • I also do not view increasing holdings of precious metals as an optimal strategy, as a resolution to raise the debt ceiling will come and place those holdings in a vulnerable position as a “charge for the exits” mentality prevails similar to what occurred in September 2011 (Figure 1.3).

 

  • I would expect moving from holdings of high yield corporate bonds to investment grade is favorable.

 

  • Government mortgages should be favored over private sector mortgages.

 

  • The U.S. dollar should appreciate as a global safe haven.

 

  • Most importantly, investors should utilize the options market to protect portfolios. Given the current low cost of options “insurance,” this might be the best strategy in preparation for the debt ceiling debate. With the VIX below 15, this appears the simplest and most prudent strategy.

Overall, investors have time to prepare for the contentious days of early March, and that alone should be comforting. This is not something that will blindside the market.  Ultimately, there will be a resolution. Quite possibly, the threat of delayed tax refunds to the electorate will be the single largest motivator for D.C. to agree upon a debt ceiling deal.   

Figure 1.1 U.S. Statutory Debt Limit 1940 to Present

 

Source: Bloomberg

 

Figure 1.2 U.S. Statutory Debt Limit 2000 to Present

 

Source: Bloomberg

 

 

Figure 1.3 Gold 2011 Prior to Debt Ceiling Debate Debacle

 

 Source: Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.