- "Mbube", by Solomon Linda and the Evening Birds (the original)
* As you may have noticed, there’s a bit of bother over the US debt ceiling, which if not increased is likely to lead to all kinds of uncertainty and seemingly anything ranging from a complete government shut-down, to downgrades of US debt, to default, and perhaps even to intergalactic warfare (okay, I might have made that last one up). Not only that but the same people who’re in-charge of coming up with the budget also set the debt ceiling (at a completely different time), which makes one wonder how they’re all “shocked” that the results of the budget they set 6months ago broke through the arbitrary debt limit they set 18months ago. Pretty much moronic all around, and the spectacle of recent weeks only adds to that.
Our Man was chatting with Mrs. OM this week, and the fact that not much has changed in the portfolio over recent weeks (a figurative lion sleeping?), despite the book’s largest position being in US Treasury bonds, came up. What better time (or possibly more foolish, depending on how things pan out) to share his thoughts with you. The short-answer is things are very uncertain and it depends on what happens, when and how: will the US actually full-on default, or prioritise payments/shut-down parts of the government (which I suspect is most likely), or will it merely miss/delay some interest payments and then see a compromise reached, etc). Clearly though, this isn’t much help in understanding how (or indeed, if) Our Man is thinking, so let’s break it down a little.
Equity books: Doing nothing here is relatively easy as the total Long Equity exposure across the equity-orientated books (NCAV, Value Equities, Other Equities & Energy Efficiency) is a mere 11.1% NAV. Thus even a substantial decline fails to produce a sizeable impact (>500bps) on performance. This is before we even consider the positive impact that fall in markets would have on the put/hedge book (51bps of premium at risk), and the manner in which this exposure (currently a mere 1.3% short) would increase as the markets fell. As such, it’s pretty clear that the equity book wouldn’t drive any major losses and that the worst possible result for it would be a market fall of ‘only’ 10-30%.
Fixed Income books (L Treasury Bonds and L Bond Funds, c58.5% NAV): In the short-run, I’d expect these to suffer should the US miss interest payments (remember new debt can be issued to meet principal payments, as the total level of debt doesn’t change) but am comfortable underwriting these short-term losses in the portfolio in all but the most extreme of scenarios (the US government saying we’ll never payback any bonds ever) and thus am comfortable with the existing position sizes. The longer-term is harder to predict, and while some expect that it’s just a continuation in the US’ path to hyperinflation, I (unsurprisingly) suspect that it won’t. More likely, any prolonged cut-back in government services will help threaten to push the US into negative GDP growth territory (after <2% GDP in Q1, and I dare say something similar or worse in Q2) and make deflation the more likely scenario. If there is eventually a debt-ceiling deal (involving cutting government spending) that sees creditors made whole (for the delayed interest payments), I believe this would be good for Treasuries! In the case of no default but a downgrade of US debt (from AAA to AA) then I’d be a buyer of US 10-Yr Treasuries on any noticeably widening of yields (i.e. the 10-Yr moving from c2.90% to 3.25-3.50%), since the headline rating is irrelevant (as seen in Japan) when compared to factors like inflation.
As an aside, when thinking about defaulting/etc there’s a subtle difference between Japan/US and Greece/Italy/Spain that’s frequently overlooked. Both Japan and the US issue debt in their own currency and are the monopolist supplier of their currency; thus, they ALWAYS have the ability to pay back the debt (through printing money) and thus should they default it’s because of their willingness to do so (see US Debt-Ceiling muppetry!). In the case of Greece/Italy/Spain they’re not the monopolist supplier of their currency and as such default is solely a question of their ability (or perceived ability) to pay off this debt. The same is true for countries that issue their debt in foreign currencies (e.g. Germany’s reparations post-WWI, or large tracts of Iceland’s debt before the Financial Crisis) as they are (by definition) not the monopolist supplier of these currencies.
Currencies: This discussion leads us nicely onto Greece, and the most recent bailout mechanism. Much like the (2 or is it 3 or 4) previous bailouts of Greece, the current one doesn’t offer any solution merely another effort to buy more time. In the end, basic arithmetic is working against Greece as even with generous assumptions it is likely that 23%+ of Greek government revenues** are needed to pay interest on their debt (no principal) before they even get around to providing any services. Clearly, that’s not a sustainable! So what does it require for Greece to go bankrupt and default? I actually think that’s simple; you need the French/Germans to not want to give/transfer their taxpayer money to Greece, and that requires France/Germany to be suffering enough economic pain, such that the political will to bail out Greece ranks behind the desire to help out French/German voters. Thus, it’s most likely Greece goes bankrupt when there’s the next bear market/recession (and Greece going late in that). Why’s Our Man still happy to be S the Euro…well, currencies are a relative value game and the for all the US’ faults, Europe is still uglier.
* Yes, the title was a gratuitous lead-in to bask in some of Mrs. OM’s photography from our recent holiday!
** How did Our Man come up with this number:
By generously assuming things haven’t got worse since 2010 (i.e. Debt/GDP stays constant) and using 144% Public Debt to GDP, a 6% interest rate on debt (vs. 16% 5-Year yield, currently), and Government Revenue of $114.5bn on a $305.4bn economy (thus revenue = 37.5% of GDP). Which gives us 144% * 6% = 8.64% of GDP spent on interest payments, or 23.05% of government revenue used solely for interest payments.
