Business Leaders Resigned to U.S. Debt Downgrade but Say Default Unlikely

BlackRock, LPL, Commonwealth, state governments urges Washington to cut budget deficit

Rep. John Boehner (left) and Sen. Harry Reid have competing plans to raise the debt ceiling. (Photo: AP) Rep. John Boehner (left) and Sen. Harry Reid have competing plans to raise the debt ceiling. (Photo: AP)

(Editor's Note: This story was written prior to the downgrade, but page 2 offers some tips on investment Safe Havens.)

With a House vote on Speaker John Boehner's bill to lift the debt ceiling delayed Thursday night, the business community is battening down the hatches for a U.S. debt rating downgrade—and they’re not happy about damage that the oncoming economic storm will wreak on investors.

An ad hoc coalition of asset managers, investment advisors and pension plans on Tuesday sent an open letter to President Barack Obama and members of Congress, begging them to “fix the deficit for real” and act now to raise the debt ceiling.

“Addressing the current federal debt ceiling crisis, by itself, will not fix the entire problem. We would be deluding ourselves as a nation. If we want strong economic growth and job creation we must fix the deficit for real, for good, for the future of all Americans,” said the coalition in its letter. “As a debtor nation, America must show the world that the nation's word is its bond. Raising the debt ceiling is vitally important, but that alone is not enough. The huge budget deficit, both current and long-range, must be dealt with urgently as well.”

The coalition is comprised of a diverse group that includes asset management giant BlackRock, Commonwealth Financial Network, Legg Mason, LPL Financial, Raymond James, Verizon, the North Carolina Retirement System, the Florida State Board of Administration, the New Jersey Division of Investment and the Teachers Retirement System of Texas.

Boehner delayed a vote Thursday night on his debt-limit bill because he did not have enough Republican support to pass it. He would need 216 votes to pass the bill and send it to the Senate, where Majority Leader Sen. Harry Reid said the bill would be dead on arrival because Democrats would not pass it in its current form. Reid is waiting for the outcome of Boehner's bill before introducing his bill to raise the debt ceiling.

Resigned to a Downgrade

While the coalition warned that America may lose its triple-A debt rating if U.S. leaders fail to act, other investment professionals have already resigned themselves to a downgrade. But the consensus is that a default on U.S. debt is unlikely. Either way, as they await an outcome on Washington’s stalemate, market players are scrambling to find investment opportunities and safe havens in light of the unpredictable state of play.

The bond market is already pondering what life will be like without a triple-A rating, asserted LPL Financial Market Strategist Anthony Valeri in an analysis written on Tuesday.

“If an agreement is not reached in time, which we view as highly unlikely, we still believe the Treasury will be able to service its debt obligations but will likely result in a ratings downgrade even if temporary. Although President Obama and Congress remain at odds over how to resolve the debt ceiling impasse, we continue to believe that a deal will be struck before the Aug. 2 deadline,” Valeri said.

Of the three major ratings agencies, Standard & Poor’s has taken the harshest tone in stating that it would like to see meaningful steps to reduce the long-term deficit in order to avoid a rating downgrade, according to Valeri. “With the Aug. 2 deadline merely one week away, time is running out, and the odds of more substantial

budget reductions being implemented in time are dimming. S&P may therefore downgrade Treasuries in coming weeks or months after it reviews any debt deal.”

But Debt Default Seen as Unlikely

In what may be viewed as a glimmer of hope, however, a debt default remains unlikely, analysts say.

Though Democrats continue to declare Social Security reform off the table and Republicans remain immovable on tax increases, “it is still our opinion that the probability of a default of U.S. debt is low,” wrote Nasri Toutoungi, head of global rates and strategy, in a Thursday commentary from Hartford Investment Management.

Even past Aug. 2, in lieu of default, the government and U.S. Treasury can take action that would put off a missed debt payment, Toutoungi said. “These actions could include the Treasury accelerating the sale of mortgage-backed securities, selling their stake in TARP recipients, or payables/receivables engineering. In addition, the government can engage in furloughs and a shutdown of non-essential government services.”

Scrambling for Safe Havens

Not content with waiting for a resolution, fund providers small and large are scrambling to offer decent investment opportunities that shelter investors from the debt ceiling storm.

adam pattiIndexIQ CEO Adam Patti (left), for example, is touting exchange traded funds and mutual funds that replicate the protections found in hedge funds.

Investors and advisors who believe the crisis will force a drop in the stock market are probably moving to cash right now, and those who believe that a deal will be reached may be moving into equities but risking a negative outcome, Patti said. But IndexIQ funds such as QAI, MCRO, MNA and IQHIX offer a solution, he said, “since they provide investors and financial advisors with downside protection in case the equity markets remain weak and volatile, while simultaneously providing upside participation if the markets respond positively.”

J.P. Morgan Asset Management, meanwhile, is recommending its Large Cap Growth Fund (OLGAX) as an attractive asset class.

“One day, the melodramas around U.S. and European sovereign debt will end,” says Michael Cembalest, chief investment officer for J.P. Morgan Asset Management, in a package of client research about the debt debate. “While we’re waiting, one of the asset classes that looks attractive is large cap growth stocks. For a universe of 300 U.S. large cap growth stocks that meet certain earnings quality and stability factors, free cash flow relative to both revenues and stock prices looks good compared to the last four decades. This is where we believe investors should be adding exposure if they are underweight versus their desired equity allocations.”

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