The Debt Ceiling Debate & China
By Russ Koesterich
July 18, 2011
Call #1: Maintain Underweight US Treasuries
This week, our first call focuses on the ongoing drama over the US debt ceiling and its implications for the US Treasury Market.
While the clock continues to tick towards an August 2nd deadline for raising the debt ceiling, Congress and the White House are still nowhere near a compromise. What is starting to emerge is an alternative plan, first floated by Mitch McConnell, the Senate Minority leader. The plan would effectively give the President the ability to unilaterally raise the debt ceiling in smaller tranches, as long as the hikes were not overridden by 2/3 majority by both the House and Senate. Such an override would be highly unlikely given the Democrats’ majority in the Upper House of Congress.
Despite recent theatrics, we still believe that the debt ceiling will be raised prior to the August 2nd deadline. However, what last week did demonstrate is that the type of grand bargain that was envisioned even a couple weeks ago is unlikely to happen. In other words, while the debt ceiling will be addressed, we are unlikely to see any real progress on addressing the underlying deficit.
This is consistent with our thesis that developed market countries rarely tackle fiscal problems ahead of an election and instead tend to do so afterwards. The implications for bond investors are that risks of a near-term default remain small, and given the anemic pace of the recovery, bond yields are likely to stay low in the near-term.
However, for those with a longer term horizon, the latest act in the deficit drama proves once again how difficult our fiscal problems will be to address. Without real fiscal reform, deficits will grow over the long-term, adding to the supply of debt and putting upward pressure on interest rates. As such, our long-term view of Treasuries remains negative, and we would continue to overweight national municipals and corporates in the fixed income space (potential iShares solutions: TLT, TLH).
Call #2: An Update on China
Next, here’s a quick update regarding our view of China. While we remain, for now, neutral on China, and hold a negative view of emerging markets in general, our stance on China is starting to shift to a more constructive, or positive, view.
The Chinese market has gotten hammered recently over concerns about inflation and resulting social tensions, policy mistakes and banking sector losses. Still, profitability in the Chinese corporate sector is on the rise. Return on assets (ROA) rose from 0.077 in May to 0.096 in June.
Any further improvement in profitability, particularly if coupled with a reacceleration in leading economic indicators, would lead us to establish an overweight on Chinese equities (potential iShares solutions:MCHI, ECNS).
Bonds and bond funds will decrease in value as interest rates rise. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.
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