pimco viewpoint washingtons prolonged saga and the markets reaction pvc107

7/27/2019 PIMCO Viewpoint Washingtons Prolonged Saga and the Markets Reaction PVC107

http://slidepdf.com/reader/full/pimco-viewpoint-washingtons-prolonged-saga-and-the-markets-reaction-pvc107 1/4

ViewpointOctober 2013

Your Global Investment Authority

Josh Thimons

Managing Director

Portfolio Manager

Libby Cantrill, CFA

Executive Vice President

Executive Office

Washington’s Prolonged Sagaand the Market’s Reaction

We have seen significant volatility and uncertainty in

Washington, D.C., over the last month: The federal

government shutdown on October 1, a leading contender for

the Federal Reserve chairman position, Larry Summers, took

himself out of consideration, and the Fed surprised markets

by deciding to hold off on tapering its asset purchase

program, citing congressional dysfunction as one of its

reasons. And a debt ceiling increase looks like it might be

taken hostage once again.

Aside from expressing fatigue with the brinksmanship in Washington, investors

are also asking what to make of the current situation in D.C. – and importantly

what it means for portfolios.

The government shutdown: How did we get here?

We were generally expecting that Congress would pass a government funding

bill void of policy riders at the last minute to avert a government shutdown.

Why? After all, not only had Republicans and Democrats passed “clean” funding

bills in the past with little consternation (as recently as March 2013), but Speaker

John Boehner had the votes to pass a clean government funding bill this time –

all he needed was to bring it to the floor for a vote.

So, why did Speaker Boehner not bring up that bill? We believe it is simplybecause of politics within the House Republican conference. In January, in order

to pass the fiscal cliff compromise, Speaker Boehner had to rely heavily on

Democrats because the majority of Republicans did not believe it was a good

deal for them; this defied the internal Republican “Hastert rule,” which states

that any bill brought by House Republican leadership should receive the

“majority of the Republican majority.”



OCTOBER 2013 | VIEWPOINT

Largely after this incident (and other votes such as funding

for Hurricane Sandy where he also defied the Hastert rule),

Boehner – and his speakership – has effectively been on

probation within the Republican caucus. If he had brought

up a clean government funding bill with no policy riders

targeting the Affordable Care Act (“Obamacare”), it

would have passed – but only with a majority of

Democratic votes and a handful of Republican votes. So

while the government would not have shut down,

Boehner’s speakership would have been at great risk.

How bad is a shutdown?

The government has shut down a total of 17 times before,

with the longest shutdown occurring during the last

episode in 1996, which lasted for 21 days. During that

shutdown, GDP growth declined by 0.3% annualized in

the quarter the shutdown occurred, but improved

significantly the following quarter as furloughed

employees received the back pay owed to them. We

would not be surprised if growth feels a similar impact this

time – approximately 0.1% to 0.2% of GDP (annualized)

in the fourth quarter for every week of a shutdown; unlike

1996, however, it is not clear whether furloughed workerswould be entitled to back pay.

While the growth impact – assuming a relatively short

shutdown – is small in the grand scheme of things, the

economy is also still grappling with approximately 1.7% of

fiscal drag associated with the fiscal cliff and sequester, so

a shutdown represents yet another self-inflicted wound to

already modest growth.

The debt ceiling is more worrisome

While the fiscal drag associated with a shutdown should

be relatively manageable, what is more disconcerting is

what it means for the upcoming debt ceiling, which,

according to Secretary of the Treasury Jack Lew, will have

to be raised by October 17. Many are understandably

worried that if lawmakers are willing to take a short-term

funding bill hostage to the point of shutdown, why would

they not take us over the edge: refusing to raise the debt

ceiling in order to advance their goals.

While we understand this logic, we do not think this is the

way the next few weeks will play out. We think that while

Speaker Boehner refused to bring up a vote that defied

the Hastert rule for the government shutdown, he would

cut a deal with Democrats in order to stave off a default

on U.S. sovereign debt, even if it risked his speakership

(which is likely on somewhat more solid ground now that

he helped to shut down the government). After all,

Boehner is not interested in letting his overarching legacy

be a government default, throwing the financial system

into disarray and dealing what could potentially be a

catastrophic blow to the economy.

Debt ceiling and government funding bill will likely

be addressed in one package

We expect both sides to back off their rhetoric and come

to the negotiating table – but not before they absolutely

have to. This likely means that we should expect the

government shutdown to last weeks, not days, right up

until the October 17 debt ceiling deadline.

In terms of a potential deal, it is unlikely that Republicans

will get any real concession on “Obamacare,” as President

Obama is unlikely to sign anything into law that

undermines his greatest legislative achievement. However,

Republicans could get a provision or two that provide

sufficient political capital, such as a repeal of the medical

device tax and indexing of Social Security benefits using

chained CPI (the Consumer Price Index of inflation).

Democrats would also insist on something for these

concessions: a year increase of the debt ceiling, funding

the government through the end of the fiscal year and

maybe even a deal on the sequester (which both sides

hate, but Democrats hate more).

Market impact of the debt ceiling debate: It probably

will not matter, but look out if it does

In short, while the market seems to be mostly sanguine

about the government shutdown, a breach of the debt

ceiling – which we feel is highly unlikely – would be

incredibly negative for financial markets.



OCTOBER 2013 | VIEWPOINT

Fundamentally speaking, if the U.S. government defaults

on its obligations (Treasury securities or other), any asset

with a dollar sign ($) in front of it is immediately

weakened. However, markets will not react meaningfully

until the very last moment.

Sadly, markets have come to expect (and accept)

dysfunction from Washington. The strong equity market

performance this Tuesday (October 1), in the first trading

day following a government shutdown, tells the story:

Markets have built up an incredibly strong immune system

to defend against most wounds the government can

inflict. Investors and business leaders expect uncertainty

regarding the government’s policies on spending and

taxation; they expect partisan politics and brinkmanship;

and they expect no compromise to happen until right

before or shortly after any deadline for compromise (see

the 1 January 2013 fiscal cliff resolution). Since we

forecast a similar eleventh-hour deal this time around,

markets will likely not have to grapple with the “what if.”

But what if?

We thankfully lack market experience in situations where

the world’s largest bond issuer, which also presides over

the world’s reserve currency and currency of choice for

denomination of the majority of the globe’s financial

transactions, decides to willingly default. However, we

believe it is safe to say that a U.S. sovereign default would

be extremely negative for U.S. (and by contagion) global

equity markets. The 13% decline in U.S. equities in the

first week of August 2011, in the aftermath of the last

near-default and subsequent ratings agency downgrade,

provides some frame of reference. Credit markets would

likely suffer materially, if not catastrophically, as well.

Perversely, the likely impact of a sovereign default on U.S.

Treasuries to U.S. Treasuries, themselves, is more

ambiguous. Certainly a default event would frighten,

confuse and unnerve a large group of Treasury market

investors – and at PIMCO we would re-evaluate our

Treasury portfolio positioning. However, a default event is

an extraordinarily damaging event to not just the Treasury,

but all of “U.S.A. Inc.” And while many assets would

certainly flee, some investors beholden to dollar-

denominated assets may decide to move up in the capital

structure of U.S.A. Inc. – shedding equities in favor of

sovereign debt securities. Their line of thinking would bethat default will lead to deeply negative growth, declining

equity markets, and therefore ultimate realization from

Congress that perhaps this was a mistake – and that

Congress should, in fact, pay its obligations. This would

mean Treasuries (particularly the front end of the yield

curve) could expect to see new demand, much like they

did in the aftermath of the August 2011 rating

downgrade.



Newport Beach Headquarters840 Newport Center DriveNewport Beach, CA 92660+1 949.720.6000

Amsterdam

Hong Kong

London

Milan

Munich

New York

Rio de Janeiro

Singapore

Sydney

Tokyo

Toronto

Zurich

pimco.com/investments

Biographies

Mr. Thimons is a managing director and portfolio manager in the Newport Beach office,focusing on interest rate derivatives. Prior to joining PIMCO in 2010, he was a managingdirector for the Royal Bank of Scotland, where he managed an interest rate proprietary tradinggroup in Chicago. Previously, he was a senior vice president in portfolio management forCitadel Investment Group, focusing on interest rate and volatility trading. Prior to this, he wasa director for Merrill Lynch Capital Services, managing an over-the-counter interest rateoptions market making desk. He has 15 years of investment experience and holds anundergraduate degree and an MBA from the Wharton School of the University ofPennsylvania.

Ms. Cantrill is an executive vice president in PIMCO’s Executive Office, where she helpsmonitor, analyze and coordinate the firm’s response to public policy issues, includingregulatory and legislative issues. She is a member of the firm’s Americas Portfolio Committeeand sits on the firm’s Policy Working Group. Prior to joining PIMCO in 2007, she served as alegislative aide to a member of Congress, where she focused on fiscal and economic policy,and she also worked in the investment banking division at Morgan Stanley. She has 10 yearsof investment experience and holds an MBA from Harvard Business School and received herundergraduate degree in economics from Brown University.

A word about risk:

All investments contain risk and may lose value.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material hasbeen distributed for informational purposes only and should not be considered as investment advice or a recommendation ofany particular security, strategy or investment product. Information contained herein has been obtained from sources believed

to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any otherpublication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks orregistered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC,respectively, in the United States and throughout the world. ©2013, PIMCO.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

Investment Products

Not FDIC Insured | May Lose Value | Not Bank Guaranteed

pimco viewpoint washingtons prolonged saga and the markets reaction pvc107

Documents