Home>Video>Separate Signal From Noise in the Debt Ceiling Debate

Separate Signal From Noise in the Debt Ceiling Debate

Mon, 14 Oct 2013

Investors should focus on a suitable overall allocation but otherwise resist making short-term trades around this highly uncertain and potentially volatile D.C. drama, says Morningstar markets editor Jeremy Glaser.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. As the government shutdown debate and debt-ceiling debate continue in Washington and we approach worrisome deadlines, joining us is Morningstar markets editor Jeremy Glaser to offer investors insights about how they should view the debate in Washington and also some tips for their portfolio plan.

Thanks for joining me, Jeremy.

Jeremy Glaser: You're welcome, Jason.

Stipp: What's the latest on the negotiation as of Monday?

Glaser: Well, on Monday afternoon it seemed like the Senate is fairly close to reaching a deal with the minority leader, Mitch McConnell, and with Harry Reid, the majority leader, and coming up with a package that would give us an extension to the debt ceiling, possibly through January. It would reopen the government and kind of set the stage for some broader fiscal negotiations to try to come up with a long-term solution.

Stipp: What are some of the things that must be in the plan in order for it to actually pass in the short time period? Because we've been close to deals in the past few days and then talks have broken down. What do you think needs to be in that compromise?

Glaser: This is a hard time to really negotiate a compromise because the leaders of the various parties and various houses of Congress don't necessarily have the full support of all of their members, which means that the deals really need to be pretty broad-based in order to get the votes and the support that are needed to have them pass.

I think there are two things to look for; the first is kind of on process and the other is on policy. Process is important here because the Democrats feel that the Republicans shut the government down and are threatening with the debt ceiling, and that if the Democrats give in to any demands that's going to embolden the Republicans to just keep doing that over and over again. And that's going to create too much chaos so that Democrats can't give into this, and that they need to accept something that's fairly clean or only has very minor giveaways.

The Republicans, on the other hand, feel like the Democrats aren't negotiating with them in good faith, and really want to feel like they're bringing the Democrats to the negotiating table, that their concerns are being heard, and that they really have a seat at the table.

Now, I think a deal really needs to help keep both of those ideas that both sides can feel like the process is working in a way that they're happy with to get a deal done. And on policy, there really aren't policy positions that both sides want. You hear the Democrats talking again now about potentially trying to roll back some of the sequester change, some of those cuts. The Republicans, obviously, want changes in the Affordable Care Act and also in some other policy areas, as well.

I think we need to see a negotiation there, as well, and I think getting both of those prongs done could potentially give us a deal that has the ability to actually pass and get to the president's desk.

Stipp: It looks like there are a few stages here. We may get some sort of short-term deal that maybe helps the government open up again in a timely manner and also pushes off the debt ceiling. But there also could be a longer-term deal that's negotiated over the next few weeks and months. Let's take those better scenarios where we actually do get something passed first.

If there's a short-term agreement and compromise, is there anything in there that investors should be aware of or that might cause them to position their portfolios differently based on what's likely to be in that short-term compromise?

Glaser: It's unlikely to make a big difference. There's a chance that something like the medical-device tax will get delayed or appealed, but that probably doesn't mean you should go out and be buying a bunch of medical-device makers. The tax, obviously, will impact their bottom lines, but not so much that it'll really change the investability of those kinds of stocks. There probably aren't a lot of provisions or changes in tax code or anything like that; it's really just a continuation of the status quo. Investors, at least in the short term, probably can be pretty happy with their current allocations.

Stipp: A lot of these short-term compromises have included language that both sides will need to come to the table for a bigger discussion about the budget, entitlement spending, and other related big-government problems. What might come from those discussions that investors should have on their radar?

Glaser: This potentially has a bigger impact. And we talked about this grand bargain before that it's probably unlikely that we're going to see something really transformative or something that's going to take place in a relatively short period of time.

I think any deal that has any chance of passing is going to reform entitlements over a really long period of time. We're talking something that's going to be solved in decades, not something in years. Chances are people who are right on the verge of retirement, about to receive Social Security, and are thinking about their portfolios, from that perspective, they probably don't have too much to worry about with changes in the entitlements. And people who are retiring in many years will have a long time to adjust to what those changes will be. I think that if they do come up with a way to make some of these programs more stable and fiscally sound over time, that reduces some of the systemic uncertainty in the system. I think that's a positive for investors.

But generally, I think the tax changes are going to be relatively mild. We've talked a lot about the potential of pretty serious tax reform. But I think due to some of the constituencies that are really tied to different credits and different deductions, the chance of seeing really wholesale reform is relatively small, and it means that changes will be at the margin. And trying to predict what those are going to be and position your portfolio isn't a game that you're likely to win.

Again, the long-term deal will have an impact on the future of the country and in the economy. It's an important conversation, but it's not one that you're going to make a big investment changes on at least in the short term.

Stipp: So, there are no urgent needs to change your portfolio, assuming that we get a small compromise here and maybe even some of the longer-term compromises that we might see over the coming months. But what about the worst-case scenario, where we don't get even a small compromise done in the next few days and we do hit that debt ceiling, what should I be thinking about my portfolio plan in that case?

Glaser: This is by far the trickier one. We just don't know what's going to happen. There's a ton of uncertainty there. And we hear some people say that it's not going to be that big of a deal, we'll be able to continue to pay our debt through taxes that are coming in, and it's not going to be a huge problem. But others are saying that it'll be absolutely cataclysmic and will be worse than the 2008 financial crisis. And I think like with a lot of things, the truth may lie somewhere in the middle.

One of the big questions is how much flexibility does the Treasury really have in terms of payment prioritization. They're technically legally not allowed to prioritize payments, but they're also legally obligated to make all their payments in full, so they're going to have to break some law somewhere, and it seems reasonable to assume that they're going to make an effort to pay Treasury interest and pay those Treasury bonds out in full before they move on to other spending. But the technical aspects of how exactly they'll do it, the vagaries of how much money comes in on any day, how much go out any day, makes this somewhat of a tricky proposition that even if they're not intending to default and they want to debt prioritize, it's not clear that they have the logistical means to do so in an efficient way.

But even if you assume that they are able to get this prioritization working and that it works pretty smoothly, there are still some pretty dire consequences for the economy as a whole. We're looking at a close to 30% cut in government spending overnight, which is a significant slice of the economy. And as [Morningstar director of economic analysis] Bob Johnson has pointed out, there are already signs that the economy is slowing down a little bit, that the government shutdown is going to kind of push that, and that a big cut in spending all at once will probably push that even further. If that slows down growth, it potentially puts us into another recession. That's going to have a real impact on what happens to the market; it's going to have a real impact on what happens to your portfolio. And we also don't know how the market's going to react.

Would debt prioritization still be seen as a soft default? Are rates going to go up? What's the impact of rising rates on the economy? Those are all a bunch of questions that we don't necessarily have solid answers to, but we can probably predict that most of them are negative impacts. There are not a lot of positive impacts from it, and I think that's something the investors should be concerned about even if they're not worried of that most cataclysmic kind of, the sky-is-falling, type of analysis.

Stipp: If I am concerned about that cataclysmic event, is there really anywhere that I could invest my money where I would be safe?

Glaser: Probably not. As we saw during the financial crisis, correlations tend to go to 1 in the heat of a crisis. We could see sell-offs really globally and across a lot of different asset classes. There's a good chance that there just isn't really going to be any kind of safe haven in the event that Treasuries are suddenly deemed as not really being safe assets and we start to see the fallout of that.

Stipp: So given that, and I'm looking at my asset allocation, what should my plan then be? There's a lot of uncertainty out there; one of them is a pretty big negative uncertain event. How should I think about my plan in that context?

Glaser: I think having that asset allocation is what's really important. Any money that you're going to need in the short term--and the short term being the next couple of years--in terms of living expenses, in terms of money that you need to pay your child's college tuition, anything like that needs to be in fairly liquid assets. It needs to be in things like cash that you're going to have on hand easily, and not be subject to the ups and downs of the stock market.

But that being said, you probably should also have an allocation--if you are not retiring for quite a long time and you still have a lot of time left in retirement--you shouldn't completely abandon equities. If you think about how many of these companies are going to be permanently impaired by a debt-ceiling crisis, and chances are that most of them will continue to operate.

There might be a lot of uncertainty and could be some pretty bad quarters in the near term, but 15, 20 years from now people are probably still going to be buying Coca-Cola which will still have pretty solid earnings, [which will be similar] for those wide-moat companies that will be able to fend off their competitors over that time. There could still be some value there, and you are going to have to see a lot of pain in the short term as those sell off with the rest of the market. But eventually we'd hope that their true value would be realized, and it would be good to hold on to that allocation. Trying to sell out completely is probably a mistake in this case.

Stipp: A lot of more of those, especially wide-moat companies' value is in those further-out years. Even if there's some trouble in the meantime, if you can look past that you can enjoy some of those wide-moat returns, so to speak.

What about having money on the side in case we do see a big sell-off and maybe if I don't own some of those wide-moat companies, I have a chance to get a position in them at a good price?

Glaser: We might get some opportunities here. That could be kind of the silver lining of a big stock market sell-off. Right now valuations are not terribly appealing. We don't see a ton of wide-moat companies that are trading at really significant discounts of their fair value estimates. If we were to see that turn around, there could be a lot of values, a lot of opportunities to kind of put some money to work particularly if you've had some cash on the sidelines for a while.

So, this isn't a bad time to think about the types of companies that you might want to own, those wide-moat, low-uncertainty names, potentially having pretty good dividends, getting those on your radar screen, and maybe doing research on those first. Or if you are a mutual fund investor, an exchange-traded fund investor, think about the kind of products that or the kind of managers that would invest in those types of companies that you'd like to get exposure to because there's a chance that you could have that opportunity.

Right now, it doesn't seem like the market is pricing in a very high probability of this kind of worst-case scenario, so there could be a pretty significant decline. And I think that it's not likely that we're going to see this worst case. But it certainly is a possibility, and investors need to be prepared for it.

Stipp: Jeremy, obviously, a very fluid situation, but thanks for giving some good traction for investors in a portfolio context.

Glaser: You're welcome.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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