Government shutdown may kill corporate debt
James Saft is a Reuters columnist. The opinions expressed are his own.
If you are worried about the impact of a U.S. government shutdown on markets, you might just want to look past Treasuries and keep a weather eye on corporate bonds.
Investors will have good reason to dump U.S. corporate debt and shares in the event of a shutdown. Given that there are $29 trillion of corporate securities outstanding compared to only $9 trillion of Treasury debt in public hands some of those sales could flow into supposedly safer longer-term Treasuries even as corporate yields burst higher.
President Barack Obama proposed on Wednesday cutting the deficit by $4 trillion over 12 years, less than a week after Democrats and Republicans struck a last-minute stopgap deal to temporarily avert a government shutdown. Even so, the political divisions are deep and there are ample opportunities in coming months for impasse to lead on to nonpayment of bills, the sort of sort-of default that would doubtless send markets reeling.
“Markets will begin to anticipate a crisis,” said Rob Dugger, of Hanover Investment Group, a former partner in legendary hedge fund firm Tudor Investments.
“If government is forced into rapid adjustment it will be the private sector that gets hurt.”
The first thing to realize is that the budget situation has profoundly negative implications for the U.S. corporate sector, which will have to operate in an environment with less money floating around and with quite possibly a higher burden of taxation.
According to Dugger, some corporations and investors are already getting to grips with this, taking or planning steps to channel investment and income in ways to prepare for the cutbacks and avoid the worst of the tax increases. He is concerned that this takes on a momentum of its own, a force that could cause a sharp sell-off but would also retard long-term investment into the U.S.
The immediate risk is that a shutdown or threat of one sends a scare into investors, who having done the math on what this will mean for corporations, start to lighten up on the stocks and bonds of the companies that will be hurt worst. The kind of “herding” that often happens during a visceral news story will only make this worse.
As many investors have mandates to hold dollar-denominated securities, that could spark a flow out of corporate paper and into Treasuries, on the presumption that the U.S. will prove a good credit over time. In the absence of a massive fall in the dollar, the U.S. almost certainly will prove a good credit, and the costs of that will be spread across households and businesses.
UNACCOUNTED FOR LIABILITIES
Hanover Investment calculates that there is an unaccounted for liability of $2.459 trillion that should be on the balance sheets of U.S. corporations, this being their share of the current value of the government shortfall over 20 years.
Why does that shortfall matter to companies? Because they will share in the pain of higher taxes, lower government spending and all those two forces imply.
Is this a big deal for corporations? Given that the corporate share of the shortfall is 8.5 percent of total 2009 corporate book equity, it most certainly is a big deal.
Much depends on how much of that pain gets front-loaded, as opposed to spread over many years. If a lack of political consensus over how to tackle the budget brings on a crisis it will actually raise the risk of sudden and severe cutbacks, the kind seen in Greece or Ireland, as opposed to the more gentle adjustments the U.S., as the owner of a reserve currency and a AAA rating, should be able to achieve.
To be sure, much of this pain is inevitable; even with perfect cooperation in Washington and a following wind, there will still be cutbacks and those will still, all else being equal, make U.S. corporations less profitable and credit-worthy, at least in the short term. Quite aside from the near-term political risk, this unaccounted for liability faced by U.S. corporations is part of the argument for emerging markets, or for that matter for other developed markets that are in better fiscal shape, rare as they are.
Much may depend on how intransigent the two sides prove; what looks like standing up for principle (or playing to one’s political base) in Washington looks like self-defeating sand-throwing from Beijing or Berlin.
A lack of accord could make investors and executives begin to more radically and urgently discount the burden of future government cutbacks on corporations, causing a sell-off that would take on a momentum of its own.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)