Subject: Essential Reading for Advisors on Debt
Read this, then forget about the Debt Deal until Tuesday (-;
Coming into the weekend, it appears that negotiators may actually arrive at a debt deal despite all of the acrimonious aspersions being cast hither and dither by all parties.
But! A sigh of relief is pre-mature. Recall that a deal was reached by negotiators in 2011, but was rejected by the Republican Caucus, throwing all into disarray with little time to course correct. On that point, this from republican Russ Vought earlier today:
“As reported, the deal negotiated by Patrick McHenry isn’t much different than a clean debt limit increase. In some respects, it’s worse because it will now prejudge the appropriations process.”
Over the past week I’ve become 50% asset manager/50% politico, as the trajectory of the economy and the markets will be determined by the result of negotiations over the coming days. Key here is to understand the probability of the legislature passing whatever is agreed on by negotiators, assuming that a deal is reached. Here are my opinions on how to frame the situation:
Rosey Scenario: A deal is reached, and it is passed in time:
Stocks will be in a stronger position and may experience a relief rally. But there is also concern about the impact of reduced spending on GDP, with some estimates suggesting as much as a 0.5% decline in GDP. This combined with narrow leadership for gains this year create the possibility of a “sell the news” event.
Bonds will be in a weaker position. News on inflation and FED speak suggest that a June rate increase is back in play. The absence of a crisis may allow the 10 year yield to power back up to 4% or beyond. Bonds were already lower in the past few weeks. They could be pushed back to break even or losses for the year absent fear of default.
Middle ground Scenario: A deal is reached, initially fails to pass the legislature, but agreement is reached and passed before the X-date
Stocks: This scenario looks the most like 2011. In 2011, stocks were pounded up to and following the eventual deal with the S&P losing close to 17% over roughly two weeks. In this case, due to the short amount of time until the X date, it could happen even faster. Considering that stocks are priced coming into the weekend based on deal optimism, it could be ugly. Recall that even though a debt limit increase was passed in 2011, stocks continued to move lower for an additional week on the US debt downgrade.
Bonds: Investment grade bonds and treasuries could rally significantly if they follow the 2011 pattern, with HY bonds likely selling off along with equities. In 2011, long term treasuries appreciated by north of 20%.
Off the Rails Scenario: Deal fails to pass until after X-Date, triggering default or the use of the 14th amendment
As I attempt to imagine the play out of this, one has to consider the possibility that McCarthy is removed as the speaker of the house, leaving the GOP without clear leadership at a time when decisions must be made. Lowering risk for the markets is the fact that once we make it to June 15, significant taxes will be received by the Govt. So, the amount of time that the Government is unable to pay its bills could be limited to between 1 and 15 days.
One final point on this option. Segments of both parties are openly expressing a willingness to default. The Freedom Caucus has said that they would be unwilling to sign any bill that is a compromise to the prior house passed bill. Members of the progressive caucus have suggested that the only option forward is the 14th amendment.iii
Stocks: Losses that potentially exceed the 2011 experience, or more than 20%. Let’s be clear. This event is unprecedented and could create a lot of what markets like least, uncertainty. I put it like this: US treasuries are the oxygen of the financial system. How long can the economy hold its breath? Under this scenario, lasting damage could be done to both the stock market and the economy, with no clear market rebound assuming there is ultimately a debt ceiling increase.
Bonds: Unknown! Treasuries have traditionally rallied during periods of market stress. However, if bill auctions fail, there is the potential that losses could resonate and affect the broader treasury market. The shot across the bow example here is the brief collapse of UK treasuries (losses of 25%) last year. Obviously corporate bonds could be negatively affected on fears of corporate stress.
Toews positioning coming into the Weekend:
Several weeks ago, as we looked at the history of debt ceiling negotiations, our management team made the decision to add “extraordinary measures” to our equities portfolios to address the possibility of a debt ceiling debacle. Those positions, which have a limited and definable cost to portfolios, are still in place as we approach the weekend. In some cases, we hold up to 150% notional value of put contracts in portfolios. That means that at certain levels of losses, there could be more appreciation in the puts to offset some losses in equities. If the market does experience severe losses, we may attempt to monetize and exit those puts.
Our algorithms moved us into defensive positions between May 10 and May 12th in our High Yield Bond portfolios.
All our stock portfolios are fully invested in a bullish posture. As outlined above, however, have put contracts in place in the event of a market event. Finally, we rolled up the LEAP put contract in our Managed Risk portfolios closer to the market, which could have the affect of bolstering loss avoidance during a risk event.
In summary, we are poised for adversity, but our equity portfolios could participate in rally on any good news.
Recent Trades and Current Positions:
Between May 10 and May 12 we moved into a fully defensive posture in our adaptive fixed income allocations.
High Conviction Tactical Models1,2:
Developed International Stocks: 100% Invested
High Yield Bonds: 100% Defensive4
US Stocks: 100% Invested
Investment Grade Bonds: 100% Cash Equivalents
Managed Risk: Approximately 4% out of the money at Friday’s market close (LEAP on SPX Futures Put strike price)
Equity Portion of Defensive Alpha Models1:
100% Bullish Posture3
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(1)These include the Toews Capital Preservation, Balanced, Balanced Income, Balanced Growth, Growth, and All Equity, High Income, Balanced Income, and Conservative Income portfolios. They do not reflect the allocations of these strategies that are not allocated to Toews Funds.
(2)Exposure to vehicles invested in the listed asset classes
(3)Approximate Defensive Allocation
(4)Approximately 9.7% are in individual HY Bonds but hedged with HY Futures for defensive positioning.