US Videos

No Winners in U.S. Default

Paul Justice, CFA

Paul Justice: With the U.S. government deadlocked over raising the debt ceiling, I have been getting a lot of questions from readers as to who wins if the U.S. government actually defaults on some of its payments. Now, this is a pretty absurd question because the real answer is that nobody wins in this scenario, and I can very rarely think of an exchange-traded fund that's going to benefit from this. Some people have posited to me that maybe stocks are going to outperform in that scenario and simply because you're going to lose some money on Treasuries. But the entire scope of the global economy is tied to the dollar, and that's likely not going to produce a favorable outcome.

So, then the next logical decision is asking "Should I shift maybe into foreign stocks? Will they be the beneficiary?" Again, those stocks are usually having a consumer that's largely weighted to the U.S. dollar, and they're going to be less likely to accept those dollars as payment. It creates a very dangerous scenario for people to begin speculating on how they can make money on this. So naturally then they decide, "OK, maybe I should be considering some commodity funds."

Now here is where the take gets a little bit interesting. Most commodity funds are going to go out and gain access to those commodities through futures markets. What we've seen recently is actually a move by the Chicago Mercantile Exchange to increase the collateral requirements it is now taking to hold those futures. It used to accept T-bills, or government notes that are very short-term, as collateral, as a risk-free investment. But if we're looking at a default, is that really risk-free anymore, and the consensus is now saying, "No, it's not." You're now having to give a haircut on some of the T-Bills now requiring a 0.5% discount as to what the value is. What this means is more people have to put up more money to buy those same futures contracts, decreasing the purchasing power of those same folks.

For a lot of commodity funds, ETFs included, that's going to require the same thing, meaning that you have less purchasing power and will likely have to sell some of those futures contracts. So, in the short term if you're using a commodity fund to hedge against this, you might be in for a bumpy ride and a disappointing result.

The final one, and maybe this one works out and maybe this doesn't, would be gold, the reserve currency for virtually every currency on the planet right now, not just the dollar. Now the problem with gold is that you are taking a speculative position. Perhaps it does benefit in the short term like we've seen in the recent rally as people flood away from the dollar and go into gold. But what if the most likely scenario comes true, and the debt ceiling actually does get raised and Congress does not default on its debts? Well gold is likely to come back down at that point in time. So, you might be in for a bumpy ride there.

My suggestion to you is stay the course with your investments and stick to the asset allocation that you already have. And also just understand that the risk-free paradigm is only in theory and is not always going to hold true, but how risky is the end result going to be if defaults don't come?

With that little thought, I'm Paul Justice, director of ETF research at Morningstar.