Today, because of the all of the talk on the news about the debt ceiling and a possible Government default, there may be many investors who are worried about what would happen to investments if the debt ceiling is not raised. To understand what the effects would be, first an understanding of the effect of interest rates on stock and bond prices is needed.
The relative return of different investments is based on the relative risk of the investment. Bank accounts are more safe than bonds, which are safer than stocks, which are safer than options, and so on. The return on savings accounts are therefore the lowest (currently between 0 and 0.25%), followed by bonds (currently between 3-8% return), followed by stocks (10-15% return), followed by options (50% return or more). US Treasuries, which have been considered very safe investments, generally return less than corporate bonds but a bit more than bank accounts because the cash is less liquid.
If the return on the safer investments increases, the return on the more risky investments will also increase. For example, if the return on US Treasuries increases to 5%, the return on bonds might move to 8-12%, and the return on stocks might return to 15-20%. The reason is that investors will require a greater return from the more risky investments in order to take the additional risk. Why would someone buy corporate bonds at a 5% return if they could by safer Treasuries which have the same return?
In order for the return on current bonds to go up, which pay a fixed amount of money per bond each year, the price must go down. For example, if a bond which cost $1000 when it is issued has a coupon of 5%, it will pay $50 per year. If the price of the bond dropped to $500, it would still pay $50 per year but now the effective return would be 10%. If you bought a bond at a par value of $1000 and then interest rates on other investments went up such that a 10% return was needed for investors to be interested in the bond, the price of the bond would drop to $500, and one would take a $500 loss if one sold the bond. If one held the bond until it matured, assuming that the company did not default on the bond, the original $1000 purchase price would be returned.
While stocks do not pay a fixed return (except for the dividend), there is an estimated return based on the expected earnings. For example, if the earnings a few years in the future were expected to double, one could reasonably expect the price of the stock to also double over that time period. If the price of bonds drops, causing the return from bonds to go up, the price of stocks would also drop until the potential return on the stocks was greater than that on bonds. Once again, a return of 3-5% above that of bonds should be expected for common stocks.
So, traditionally the price of stocks and bonds drops when the return on Treasuries increases since Treasuries are normally the safer investment. If the return on Treasuries increases because the US begins to default on its debt, however, Treasuries may no longer be considered the safer investment. In that case, the price of stocks and bonds may actually decrease as investors move from Treasuries into corporate stocks and bonds.
If the US Government reduces purchases, that would affect the earnings, and therefore the price of certain stocks and bonds. For example, if the Government needs to cut defense spending, defense stocks would drop in price. Their bonds would also become more risky, so their price would also decrease. This effect would be muted, however, since the Government really doesn’t inject money into the economy since it takes the money that it spends out of the economy.
Deficit spending does have some effect, but it mainly just increases current economic activity at the expense of the future. When the spending stops, there is a decline in earnings and revenues. Because stocks are forward-looking, meaning that people price them based on what they expect the future to hold, the price may actually not increase due to deficit spending (see the results of the recent Stimulus Plan). If the Government raises taxes, that would have a greater effect than simply reducing spending since it would then be pulling money out of the economy, which would decrease corporate earnings, causing stocks and bonds to decline. Ironically, the revenues received by the government can actually increase when taxes are lowered due to the additional economic activity and vice-versa (see the Laffer curve).
So, the bottom line is that investors should not really worry about a US default. If one has a long time horizon, one should continue to invest regularly and stay mainly in equities. There may actually not be that great an effect on asset prices. If one needs the money within the next few years, as always one should be pulling money out of stock and bonds and build up enough cash to weather any economic storm.
If the US does default and that actually leads to a worldwide economic collapse, it won’t matter where one has money. If it doesn’t default, or a default just affects the Government’s credit but does not affect the markets, one will want to be fully invested to take advantage of any resulting run-up in stock prices. If there is a drop, one may be able to pick up equities at great prices, leading to higher returns in the future.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.