Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life.

For today’s Soundbites, we’re talking about the U.S. debt ceiling with Paul Mielczarski, head of macro strategy at Brandywine Global Investment Management. We talked about how the U.S. got here, and how critical it is to find a solution. And we started by asking about the latest developments in the saga.

Paul Mielczarski (PM): Towards the end of last week, I think investors were generally quite optimistic that we would have some sort of a deal reached by this weekend, if not by Monday. And that’s why you saw a, sort of, sharp rally in equities, a sell-off in safe assets like bonds and gold. In some ways, I’m not that surprised that we didn’t get a deal on the weekend. I think in these types of negotiations, both sides really have an incentive to bargain to the last moment, to extract maximum concessions. The financial-market response, it’s actually been very benign, which tells you that most investors do think we’ll ultimately reach a deal. But I feel like we’re in a bit of a catch-22 situation. You need a financial-market reaction in the form of a large equity sell-off for Republicans and Democrats to really come together and reach a deal. And that’s what happened in 2011, during the last confrontational debt-ceiling standoff. Investors don’t want to sell stocks if they think a deal will ultimately be reached. So that’s why I think you’re in this catch-22 situation right now.

Domestic ramifications of failing to raise the debt ceiling.

PM: If we actually got to a situation where a bond interest payment were missed or social security cheques were delayed, I think there would be a huge reaction, both in financial markets and in public opinion. I think you could easily see a 15% or 25% equity market sell-off, maybe more. I think it’s very likely you would have a U.S. recession in the second half of the year. One thing which is pretty clear is that there will be potential for some very severe financial-market dislocations. Just hard for us to really judge the full consequences ahead of time.

International ramifications.

PM: I guess I would expect a similar reaction in global equity and fixed-income markets. So, you know, equities globally selling off a lot, bonds rallying just on the view that you were likely to have a U.S.-led global recession. And then, given the importance of the U.S. economy, we’re likely to see a significant negative impact on business and consumer confidence around the world, investment plans, employment plans, etc. In terms of what does it mean for the currency markets, I feel like the dollar reaction could be mixed, actually. So, I would expect the dollar to sell off quite a lot against the euro, Swiss franc, and the yen, because these countries would generally benefit from a shift in global assets away from the U.S. On the other hand, if you look at currencies like Australian and Canadian dollars, some of the large emerging-market currencies, I think they’re more likely to underperform, just because these currencies tend to be pretty closely linked to the global growth cycle and equity-market performance. They tend to export commodities, so in a global-recession scenario, they would likely struggle.

Obstacles to a permanent solution.

PM: Some ideas under consideration is invoking the 14th amendment, which would effectively suggest that the debt ceiling is unconstitutional. Another idea is that the Treasury could mint a large-denomination coin — like a trillion-dollar platinum coin — and deposit it at the Fed and use that to pay its bills. Now, the problem with any of these work-arounds is that they create a lot of legal uncertainty. An investor might be reluctant to buy any new U.S. treasuries which could be subject to that legal uncertainty.

And, finally, how should investors position themselves if a timely solution eludes the U.S.?

PM: Yeah, so look, I mean, if there’s no resolution to the debt-ceiling standoff, that would definitely warrant reducing exposure to equities, credit, and other risky assets, and increasing exposure to government bonds. On top of that, cash is currently an attractive asset. Equity valuations are already quite elevated, particularly in the U.S. Now, there’s already a significant risk of recession in the second half of the year. In terms of a longer-term solution, I’m less optimistic and, as I said, I think we’re likely to be facing these debt-ceiling stand-offs on a somewhat regular basis.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Paul Mielczarski of Brandywine Global Investment Management.

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