Today, investors are struggling with the possibility of a US government debt default, which is the Republican’s weapon of choice in negotiation with the White House. When measured using outstanding debt, the US government is 23 times larger than Lehman Brothers, hence its impact if a default occurs, is unthinkable. While Lehman Brothers defaulted due to the inability to repay her obligations, the US government is bickering over whether it should pay her bills to pursue political goals.
Despite increasing fears, especially among foreign investors that the US would default on her debt, investors should note that the US has the ability to repay, unlike Greece, or some Latin American countries. Lumping the US with these countries does not make sense. The US economy has been growing and so have tax revenues (Figure 1). This is why despite having a budget deficit for the longest time, US debt is the most sought after fixed income instrument, especially in times of distress.
Figure 1: US tax revenue has been rising
Putting aside the economic questions, investors need to focus on how the political negotiation between the White House and the Republicans will play out. Neither are wishing for a default, yet both are adamant that their political goals are achieved. This means that last minute negotiations are likely (to increase the pressure on the other party) or a short term solution is agreed (kicking the can down the road while negotiations continue). Investors also need to bear in mind that mid-term elections are due in November 2014. Should we get a default that will result in a recession, the Republicans are likely to be the losers since current opinion polls show discontent more with the Republicans than the Democrats.
It is thus important that the parties talk with each other. A willingness to negotiate creates a situation where additional information from the other party can be obtained and compromises be made. This makes finding a solution, even a temporary one, more probable.
Our position remains unchanged
We do not expect the US government to default on its debt obligations but markets will remain volatile until a compromise is reached. When that happens, markets will focus on what’s happening in the real economy.
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