The US Debt Default Scenario for Investors

Media is having a field day discussing the nightmare that will unfold on the citizenry if US does default on its federal debt. No doubt that the possibility exists, and a US debt default will have a large impact on our personal finances. But as value investors, we are more inclined to look past short term upheavals and focus on the long term implications. Furthermore, the more appropriate question for investors ought to be, what does it mean for our portfolios going forward, if the unlikely scenario does come to pass.

Here are a few thoughts that come to mind, in no particular order:

1. A Debt Default is Not End of the World

The markets are fickle. Sure, the US will lose some of its moral authority, and some might argue, even its reserve currency status. But the thing is, there is no real alternative. In time, there might be, but not today. Europe is having its own problems. There might be a cascading effect, but once it all settles, life goes on and the US will stay as a financial superpower.

2. Panics are Great Buying Opportunities

You knew this was coming! There are no solid arguments that say that the US economy is doomed for ever. When Russia defaulted on its external debt, it set up a low that rewarded investors spectacularly. Whether you are looking for stocks or real estate, if you have cash you would want to scoop up the opportunities that present themselves. Interestingly, Navellier reports that historically markets have done phenomenally well in the month/week/day a major country (read: US) defaulted on its sovereign debt.

Caution: A default will have a cascading effect in the debt markets. Since treasuries will not be safe anymore, they will no longer be a sufficient collateral for the financial institutions and will therefore cost more in terms of interest rate that is demanded. A financial system that uses treasury rates as a benchmark will feel the ripples. Corporate debt will become more expensive as well, specifically for the companies that do not sport the AAA rating. In this scenario, it is best to stick with stocks of companies that have zero to very little debt on their balance sheet, such as the ones we focus on in the premium stock picks section.

3. It will Clean the Financial System

Bold steps will need to be taken and many of these will address the pesky inefficiencies in the American financial system. Perhaps the tax code will finally be simplified and the loop holes closed. There might be a restructuring of some of the federal programs that are currently in red or are living on borrowed time.

4. More Inflation Will be Good for Asset Values

US currency will lose ground and inflation and interest rates will pick up. This means that asset values will gain. Real estate may become a good case study. On one hand, homeowners with fixed mortgages will come out better off as their home values increase but the mortgages lose value in real terms. Those with adjustable mortgages may not benefit as much as the interest rate resets kick in. Stocks on the other hand should do well, once the initial shock to the system is absorbed.

5. Cash will be the Worst Performing Asset Class

There is safety in cash but not when inflation keeps eating away at the value of the cash. If you are in cash now, you would want to get invested in tangible assets such as real estate or stocks. There should be plenty of opportunities to find undervalued stocks in such a scenario.

A sovereign debt default is never a pleasant experience, least of all if it is a country the size of United States. Still, if this were to happen, investors who keep their eyes open to opportunities will be well rewarded, and not without justification, since investing in times like these would be a way of helping the country and its industry get back on its feet.

Comments

  1. Frank Nichols says

    I think it’s fine if you happen to be sitting on a mountain of cash that is not currently invested in anything, or if you happen to be a financial institution. However, if you are part of the vast majority of people whose 401ks and IRAs are currently in the stock an d bond markets, then this advise is dead wrong. You will once again, (third time’s the charm?), watch a sudden and enormous erosion of your current holdings. Three times in the span of 12 years really defeats the theory of long term investing, especially if you have already retired or plan to retire within the next 5 years.
    Downgrading US Treasuries will only do one thing, give the same folks that drove the bus off the cliff in 2008 another large bonus. Financial organizations will come out the best as the charge more for their loan products. Everyone else, will lose, badly.

    • says

      Frank, short term events have a tendency to color our judgement when investing. That is the reason most investors over react and end up either buying at the highs or selling when panic sets in. But point is well taken. If your investment horizon is only about 5 years, than a long term stock portfolio is not the best way to go about it.

      I do not think that the Financial institutions will perform well if the US Treasuries were to be downgraded. They would charge more for the loans, but they will also need to pay more for the money that they borrow (from Treasury, other institutions, in the capital markets and depositors). A high interest environment benefits no one – it makes doing business more expensive and puts pressure on jobs and lending.

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