Investing in Debt Ceiling Deals

Do you think politicians in Congress have been watching too many superhero movies? The timer on the bomb counts down the remaining seconds, while our hero swoops down at the very last second to save the day. That’s what’s playing in the political theater in Washington.

The only difference here, though, is that our would-be heroes are the very ones who put us all in danger in the first place. While the majority of Congress wants to reopen the government, pass a budget, and raise the nation’s borrowing limit, a powerful minority is holding out for a better deal.

To really build up the suspense, just last night Republicans pulled their offer off the table, once again increasing the possibility of missing tonight’s midnight deadline, prompting Fitch Ratings to put the U.S. government on notice for a possible credit rating downgrade.

While some members of the House of Representatives downplay the severity of missing the deadline to raise the government’s borrowing limit, others are sounding the alarm, predicting the dollar’s debasement, a complete market meltdown, and another crippling recession – not just for America but also the entire globe.

The Senate’s Proposal

The U.S. Senate – currently comprised of 52 Democrats, 46 Republicans, and 2 Independents – worked out a plan that would reopen the government and fund its operation through January 15^th (at which point it would likely shut down again) and allow the government to continue borrowing money to cover its expenses and debts until February 7^th (at which point it would likely release the sequel to this movie).

It is by no means a solution, as we would merely be right back where we are now in four months’ time. But it would at least buy more time to work out something everyone can agree on.

“We’ve made tremendous progress,” Bloomberg cites the Senate Majority Leader, Democrat Harry Reid, speaking on the Senate floor with the Senate Minority Leader, Republican Mitch McConnell. But “we are not there yet,” he cautioned.

Some highlights of the Senate’s plan:

• Congress would have to raise the government’s debt limit without add-ons or policy conditions.

• A 2.3% excise tax on medical devices sold in the U.S., which would be used to make them more affordable to lower income patients.

• An offer to delay by one year the “transitional reinsurance fee” – an annual tax on medical insurance plans for three years to help insurance providers build a pool of funds to cover the needs of high-risk patients.

The House’s Counter

Unhappy with the Senate’s plan, the House of Representatives – currently comprised of 232 Republicans and 200 Democrats – came up with a counter proposal of their own. However, shortly after lunchtime yesterday, President Obama rejected the House’s counter.

So back to the drawing board the House went and quickly drew up a second counter-proposal, which includes:

• Shortening the reopening of the government, funding its operations to just December 15^th, not to January 15^th as proposed by the Senate, thereby applying pressure on the Democrats to return to the bargaining table and negotiate a final budget sooner.

• Stopping government contributions to the healthcare insurance plans of elected officials, lawmakers, and political appointees, such as members of Congress, the President, the Vice President, and cabinet ministers.

• Barring the Treasury Department from using the “extraordinary measures” provision, which permits the government to ignore spending limits and keep spending well beyond the deadlines.

• Refusing the Senate’s proposed one-year delay of the transitional reinsurance fee, which is seen as a favor to Democratically-aligned unions.

• Changes to the Affordable Care Act, including abolishing the individual mandate obliging most individuals to sign up for at least the minimum insurance coverage or pay a penalty, and removing the requirement for employer-paid health plans to cover contraception costs.

As a demonstration of its willingness to negotiate, the House omitted from the new plan its previous demand for a delay of the medical devices tax.

But it seems to have been just an exercise in futility, as the House of Representatives canceled its voting session on the revised counter-offer, claiming it can’t get enough votes among its members to pass it.

Markets React

Shortly after President Obama rejected the House’s first offer by midday on Tuesday, equity markets started falling, with the S&P 500 ending the day down some 12 points, or 0.71%. Some safety plays edged up as expected, including gold, which rose some $15 on the news.

The 10-year Treasury initially rose some 2 basis points as the default gage’s needle moved a little closer toward the danger zone, but it quickly settled down again as the markets expected the House’s second proposal would pass.

Well, that second proposal didn’t even make it out of its own House, and since about 10 pm Tuesday night until 7 am this morning, the 10-year has risen some 3 basis points again, while gold is holding to its after-hours gains.

Credit rating agency Fitch Ratings officially put the U.S. government on notice for a possible credit rating downgrade. “Although Fitch continues to believe that the debt ceiling will be raised soon,” CBS News cites the firm’s press release, “the political brinkmanship and reduced financing flexibility could increase the risk of a U.S. default.”

Yet the firm believes it will not get to that. “Even if the debt limit is not raised before or shortly after 17 October, we assume there is sufficient political will and capacity to ensure that Treasury securities will continue to be honoured in full and on time,” they reassured.

In truth, while October 17^th is the official deadline for increasing the government’s borrowing limit, the Treasury does have enough cash on hand to continue payments until sometime between October 22^nd and 31^st. So America will not explode if a deal isn’t reached by midnight tonight. Though investors may wish to protect their portfolios from possible U.S. downgrades.

Possible Market Moves

The last time the U.S. government’s credit rating was cut, on August 5^th, 2011, the S&P 500 fell some 150 points (11.9%) in a week. That’s right, the S&P. For its part, the Dow fell some 1,300 points (11%) over that same short period. Interestingly, equities had formed a double top leading up to that correction and had been falling for about the week prior – as is the case this time around.

The last downgrade triggered a flight to safety, with gold skyrocketing some $250 (or 15%) in three weeks, while the 10-year Treasury rose some 0.75% within one week on its way to a total jump of 1.25% by the end of two months.

It is strongly unlikely that politicians will be so foolish as to allow the U.S. to skip its debt obligations, as they will almost assuredly work out a proposal that both sides can accept. Yet while a default is doubtful, a credit rating downgrade is very much a possibility, and investors may wish to prepare for one.

Since any adverse reaction by the markets is likely to be sharp and quick, in this case put options might well be worth their cost. Remember that options depreciate over time and are most efficient if held for very short periods of time as a protection against sudden moves. Gold and Treasuries may also serve as wise defensive plays.

When the danger of default passes and the government reopens, the healthcare sector may stand to benefit greatly, as Obamacare survives the challenge against it and government funding of health insurance kicks into gear. Recent losses to healthcare providers – such as UnitedHealth Group Inc. (NYSE: UNH), which had fallen as much as 7%, and Aetna Inc. (NYSE: AET), which dropped some 8% – have already been partially reclaimed.

Since the Republicans seem to have accepted the medical devices tax, look for some downside pressure on medical technology companies that produce artificial limbs, joints, and other interventional and restorative therapy products, such as Boston Scientific (NYSE: BSX), Medtronic (NYSE: MDT), Stryker (NYSE: SYK), and Zimmer Holdings (NYSE: ZMH), which were down ranging from 0.2% to 1.1% yesterday.

While defense sector stocks have also corrected over the shutdown – with Lockheed Martin (NYSE: LMT) and Raytheon (NYSE: RTN) falling some 8% in the thick of it – they have since regained about a third to half their losses. Government contractors may still have more room to correct over coming days but should bounce back up nicely on the government’s reopening – whenever that happens.

Until then, keep any margin use light, take some of the profits out of your winners, and keep some cash on hand ready to buy on the dips. That is, of course, until January and February, when the stage curtain goes up for Act 2.

Joseph Cafariello

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