Jeremy Glaser: For Morningstar, I am Jeremy Glaser. As the debate over the debt ceiling rages ahead of the August 2nd deadline, I am here today with Francisco Torralba. He is the economist at Morningstar Investment Management. We're going to take a look at what the impact of a potential default or downgrade of the United States could be for investors. Francisco, thanks for joining me today.
Francisco Torralba: Thank you for having me today.
Glaser: So let's start with just kind of a big question about, what kind of plan do you think Congress will be able to put together or would be potentially be able to pass by August 2nd?
Torralba: Well, we have two days now to August 2nd, not including the weekend, but maybe four days including the weekend. There is not enough time to put together a fiscal plan that will avoid a downgrade. There is time to put together a plan that will avoid a default, like by raising the debt ceiling.
Glaser: So, let's take a look at that downgrade then, particularly if the United States were to go from a AAA credit rating to a AA credit rating. Could you talk through some of the implications of that if we do manage to avoid a default?
Torralba: Well, I think the downgrade is going to happen no matter what because it really depends on the long-term fiscal outlook, as S&P has mentioned many times. So regardless of whether they raise debt ceiling by August 2nd, a downgrade is going to happen. I don't think it would have very dramatic consequences if just a downgrade happened; that's just a downgrade, not a default or anything else. This is because essentially there is no substitute for U.S. Treasuries in terms of liquidity and credit quality. When you look at those two characteristics combined, there is no other asset class with the same liquidity and credit quality.
Think about, for example, the daily volume of U.S. Treasuries is really about $580 billion per day. The second-most-liquid sovereign debt in the world will be U.K. gilts, and they have about 5 times less liquidity than that, so just as an example.
Glaser: So even if there was a downgrade, it's not like investors can all of a sudden rush out to some other asset class or rush out some place else. But if we were to look at potential defaults, would that change your opinion about the impact that could have on investors?
Torralba: Well, yes and no. It's a bit complicated, but let me try to explain briefly.
If they fail to raise the debt ceiling, the Treasury might still try to avoid a default by keeping the payments of debt, but stopping payments on other things, like payroll or payments to contractors and suppliers to the U.S. government. And potentially there could be shutdown of the government. So, all non-essential activities would be stopped for a while. The repercussions of that could be very serious, because macroeconomic growth is already pretty weak. If you add that additional headwind, you might tip the U.S. economy into recession. And that is the scenario I am fearing the most today--actually the last couple of days, perhaps--that the U.S. Treasury tries to avoid this default and will tip the economy into recession.
Glaser: So even if we have this prioritization of payments and we're still making interest on principal payments, but we shut down a lot of the other government, we could still run into problems even if we avoid that technical default.
Torralba: Actually, potentially it could be worse to avoid a technical default and shut down other parts of the government. It would have very vast macroeconomic implications.
Glaser: So let's take a look at other bond prices. A lot of bonds, corporate bonds, in particular, are priced as a spread to treasuries. Do you see a big dislocation in the Treasury market that could affect other credits? What do you think the bond market will do in the case of a default?
Torralba: Well, I think an interesting place to look at is the muni market because it's difficult to conceive that some state and local entities that issue muni bonds can keep their AAA rating--some of them do have a AAA rating--when the federal government does not have that rating anymore.
There is a more or less implicit guarantee that if a state or a municipality gets in trouble, the federal government will bail it out. But if the federal government is not as strong as it used to be in credit terms, then that guarantee is weaker. So, there should be probably a downgrade of the AAA muni bonds. For those that are graded way below AAA, like California or Illinois, it doesn't necessarily have to have an impact right away. Those states are rated single A for their own merits, or I should say lack of fiscal merit. So, it wouldn't be only down the road when those states, if and when they get in real trouble paying back their debt, that U.S. default would have a negative impact on that debt because the U.S. government wouldn't have a AAA rating. The market would realize, "Well, maybe the federal government cannot rescue them." So, those state debt and muni debts would suffer more than otherwise.
In the corporate debt market, I think that in the short term, there's likely to be a higher volatility and a widening of spreads. Beyond that, it really depends on what happens with the default, whether there's an actual default or no default. If there is no default but there is a government shutdown, and the shutdown is prolonged for a few months, maybe as little as two months, I can see how the credit spreads would widen very sharply, and there will be essentially a flight away from all risky assets, including equities.
Glaser: So, certainly, it sounds overall that a default or a government shutdown would certainly have very negative impacts on growth and could be a big drag on growth, but probably would not be a catastrophic outcome.
Torralba: No. I think there will be a catastrophic outcome if there was a prolonged government shutdown. That is really the most negative scenario right now. A short shutdown or merely a downgrade or merely a brief default, I don't think will have a big impact.
Glaser: Francisco, thanks so much for sharing your thoughts with me today.
Torralba: You're welcome.
Glaser: For Morningstar, I am Jeremy Glaser.