Fiscal Chicken Hedging? It’s a Tender Situation

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I wouldn't say that we will enter in a phase of lower return structurally, but I sense that we have ahead of us, a period with certainly more complicated returns.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard is Ludovic Subran. He's the chief economist at Allianz, and we'll hear from him on where and how to invest now. We'll also talk about the debt ceiling standoff, including Wall Street forecasts and a review of the rules of fiscal chicken. Listening in is our audio producer, Meta. Hi, Meta.

Hey, Jack.

We heard some concerns, didn't we? Some notes, a bunch of notes from listeners who were, who had questions about the audio quality the past couple of episodes. It's an oopsie on our part. We changed our location and they're building these audio studios at work, but they weren't quite ready. So we jumped into a different room and I don't think it's been working out, but it's not Meta's fault, of course. And we've got our regular setup for now until the new studios are ready. I think the audio quality should be all right. How does it sound?

I think it sounds great. If you jump into a cab and go to the nearest airport, okay, we'll roll from there.

Just right on the tarmac next to, let's say, an arriving or departing plane. Would that be—

Sounds perfect.

I was thinking I could just back away from the microphone and take like an empty paper towel roll like this. Just kind of talk you through it from over here. Maybe do some pig noises. You know what? We'll, we'll work on it in a little bit. For now, how about we get to some listener questions?

Yeah, that sounds good.

Hey, Jack. My name is Oren Saltzman.

Love the show.

Here's my question. I've been following politics for a long time. I'm pretty convinced that there's going to be some period of default and some short-term volatility that goes along with that. That's a strong prior belief I have. Based on that, I have no desire to go run and invest everything I have in bars of gold or do anything super extreme and try to time the market or anything foolish like that. But I would like to hedge somehow. And there don't seem to be that many great options for how to do that. So how do you hedge against a default? Do you do it with options, but just a smaller concentration, a smaller volume? Do you buy gold? What do you do? Thanks.

Thank you, Oren. Such a timely question. You haven't asked whether to sell out of stocks, but we will talk about that a bit later. Your question is how to hedge. Let's talk about the debt ceiling and hedging. Meta, everyone knows by now what the debt ceiling is, right? Are there people out there who would like me to explain it? There's like 4 of them, right?

Yeah, only 4, but you do not want to disappoint those 4.

I hear you. Okay. The debt ceiling is a limit on how much the US government can borrow. It's a law. It has to be changed every so often by Congress. It has to be increased as we spend more money than the government takes in and the debt rises. Now, it's separate from the laws on how the money is going to be spent, the budget, right? You pass a budget, you spend the money, and then you have to vote down the road to say, and we're going to increase this sort of made up limit so that we don't go over it and trigger a default. Why does that thing exist? It dates back to World War I. There was a law that was actually meant to make borrowing more flexible so that the country could scale up its military quickly without having to come to Congress for each new piece of spending so that, you know, Congress wouldn't have to micromanage every decision. But starting around the time of the Korean War, it has been, let's say, weaponized to force spending negotiations, right? One side holds up the other side from increasing the debt ceiling to get something that that side wants. And that has been growing more frequent and more contentious over about the past 30 years. There have been ideas out there on how to avoid debt ceiling standoffs. There was a 1979 rule. That automatically raised the debt ceiling with each new budget. And there was a 2011 proposal that would let the president raise it unilaterally unless Congress decided that it didn't want that. But neither of those two measures holds sway today. Now, here's what Goldman Sachs says. There's a 70% chance of a full-fledged deal before early June. Congress might suspend the debt limit until 2025. In exchange for some caps on spending. Why early June? Well, it's complicated, but the government actually ran up against the debt ceiling back in January, and then it went through some special measures to buy time until tax payments came in in mid-April. But it is now out of those special measures, no more gimmicks, no more knobs or levers to pull, and they have to make it until mid-June. In mid-June, there's another tax deadline where, where people who make quarterly estimated payments have to get those payments in. So the government will get more money by mid-June, but it looks doubtful that it can make it until then with the money it has. Goldman estimates that the Treasury might run out of money around June 8th or 9th. So what happens then? Well, one possibility is that the Treasury decides it's going to delay other payments while continuing to service its debt. Other payments include things like Social Security and Medicare and other benefits. And it only has to make it, remember, a week or so until new money comes in. And after that, there are actually some new special measures that will become available at the end of June. So there's a possibility that this thing could drag out through the month of July into August. Goldman says there's also a 15% chance of a short a term extension instead of a full deal. There's a 5% chance that the deadline is pushed back. There's a 6% chance that the Treasury lets some of those payments lapse while it continues paying the debt. And there's a 4% chance that the Treasury just keeps borrowing and goes over the limit. Goldman says that missed debt payments are unlikely and so are ratings downgrades. But then Fitch, one of the ratings agencies, just put the U.S. on ratings watch negative. So we'll see.

Jack, what do you think the percentage is that Goldman made up all those numbers?

I'd say pretty high. I put it at 89%. I think that their economists kind of say as much. You know, you can't measure something like this. The takeaway is that they view a default as an exceptionally low probability event, and they're not alone. Northern Trust says the risk of default is very low. UBS also says it's very low, but they say if it did happen, the stock market could plunge 30%. Why 30? I don't know. Wells Fargo says we believe the risk of default is low and strongly prefer not to manage portfolio exposure around the debt ceiling. In other words, keep doing what you're doing. Now, Oren, you said you think there's going to be a default, and I guess I'm somewhere in between you and all these Wall Street banks. I'm not as certain as they are. I don't quite know. And here's the way I think about it. I call this fiscal chicken when these two sides stand off like this. And the whole deal with fiscal chicken is you have to make the other side believe that you're willing to self-destruct in order to have leverage to get something that you want. And Meta, I know what you're thinking. This is exactly like that tractor scene in the 1984 movie Footloose. As listeners will surely recall, Kevin Bacon's character prevailed in that tractor chicken contest, not because he was so brave, but because his shoelace got stuck and somehow that stopped him from hitting the brakes and stopping his tractor. I don't know how that happens. I'm not a tractor mechanic, but his opponent bailed out and his tractor rolled over into a ravine and, you know, Kevin and his crew were cheering about it. And I think if we extend that metaphor to the debt ceiling standoff today, then Kevin Bacon's character might be House Speaker Kevin McCarthy. He's already named Kevin, and I think he's got Kevin Bacon hair, I'll be honest. And if he's Kevin Bacon, then I think the shoelace might be those members of Congress who initially opposed his speakership. He has to keep those people happy. He has to take a tough stand here. He's shoelaced to the tractor accelerator. I don't know. I'm still working on the details of the metaphor. Well, no matter which way you see it, I don't think the Bonnie Tyler song Holding Out for a Hero is the right soundtrack in this instance. We'll see. What I keep hearing from people is that the market seems calm. So the market is telling us that there's going to be a deal. Also, there has always been a resolution in the past. So we're going to get there again. Everyone's just posturing and fine. Maybe that's the most likely scenario. But when you're playing fiscal chicken, don't you have to scare someone? Don't you? Isn't the whole point that you have to create a little bit of financial chaos so that the other side takes you seriously and feels in a rush to reach a compromise. I'm not saying something's definitely going to go kablooey. I'm just saying it feels like the chances are higher than the market or other investors seem to be recognizing. I guess another way to put it is if the participants came up with a timely deal right now and we put the matter behind us for years to come and everything was solved, That would be a reasonable outcome. But if both parties were reasonable, why are we this close to a U.S. default? Why am I talking about Tractor Chicken and Kevin Bacon? That doesn't sound reasonable. So Put Me Down is not quite as confident as those Wall Street banks. But when it comes to the matter of hedging, the choices just aren't great. What do you buy when you're worried about risk? You might buy U.S. Treasuries. But what if we're talking about the risk of a default in US Treasuries? Now, the thing that you usually go to as a haven is the thing that seems risky. So what are people going to buy this time around? Maybe the same thing. Maybe especially if they think that this default, if there is one, would just be short-term and mostly posturing and people will figure it out eventually so that Treasuries will still be perceived as, as ultra low risk going forward. Even if there's a technical default in the short term, they'll figure The US will make good on the money somehow and that they're better off staying there than in risky assets like stocks. So, a scare on US Treasuries could make Treasury prices go higher. I know that sounds crazy, but we haven't really seen how this plays out. And as for stocks, if you're talking about long-term risk management, I just don't know what a better bet is than buying shares of good businesses that are run by people who can respond in sensible ways to changing conditions. To me, that's better than a fixed instrument with a fixed payment over time that can't do anything to respond. And it's better to me than a commodity like gold that just sits there being all beautiful with its shiny self, but doesn't really do anything to change. So I'm inclined to agree with Wells when they say don't make any big adjustments to your portfolio for the debt standoff. If you want to hedge a stock portfolio directly, you can do it. You can buy put options on a stock index that would grow more valuable if the index declined. The problem is those cost money and you have to not only be right, you have to be right soon because the longer you hedge, the more you pay. You can also buy one of these inverse stock market ETFs that pay off again if the stock market dives, but a similar thing is true there. On average, the stock market goes up over time. So you wouldn't want to spend any amount of real time in an inverse stock market ETF. And although it looks like stocks are expensive and it seems almost out of the question that at this moment where we're just coming off a bank crisis, where we're worried about the economy, where valuations seem high and where we're talking about a debt ceiling standoff, it seems like stocks couldn't possibly push higher, but Often in those types of scenarios, they do. So, Oren, hedging comes with a cost. If I were inclined to do it, I would probably just sell off some stocks and keep some extra money in cash. And you might think, well, the value of the dollar could decline in the event of a default or fear of a default. But so far, that's not what's happening. Money is flowing into the dollar recently. Anyhow, I'm not doing any of those things. I'm just going to stick with what I have been doing. Meta, how about we take a quick break now? And when we come back, we'll answer another listener question.

Sounds good.

How's the chicken feel about it? That's a yes. We'll be right back.

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Welcome back, Meta. We had another question that kind of fit nicely with the first one.

Yeah, we do, from Wolfgang.

Hi, Jack. Hi, Meta. This is Wolfgang. Wolfgang, you would say in the US. I'm a German and I live in Cascais in Portugal, a very nice place to live. I love your show. The first thing on a Saturday morning is listen to your show. I have a question about this sell in May thing. Is it a myth or is it a good idea to sell in May and go away and don't forget to come back in September?

Thank you, Wolfgang. Shout out to Germany and Portugal, and especially Germans living in Portugal. Your question is about whether to sell in May and go away, which I think is particularly timely because of this debt ceiling standoff. But it's already late May and the deadline is in early June. So it's coming up on a sell in June type of thing. I don't have a rhyme for that. Meta, we have anything? Sell in June and Don't be a prune. I was so sure you were going to go with spoon or doubloon, maybe baboon.

My second runner-up was cocoon.

Back to your question, Wolfgang. Earlier this week, I spoke with Ludwig Subran. He's the chief economist at Allianz, a giant global insurance company. Global money manager. And I asked him about what kinds of things he was hearing from investors. He mentioned the liquidity crunch and the bank turmoil, whether a recession is coming, and the bubble that might be forming in tech. We've spoken about that too on this podcast recently, that stock prices in the tech sector have accelerated even with the economy slowing down. Plus, of course, there's the debt ceiling standoff. And I asked Ludwig your question, considering all of these headwinds, Should you sell in May? Here's Ludwig.

Let's say that I'm not particularly psyched by the US stock market right now. I would be more on the bear camp. I don't know if it's because it's May that you have to sell or because Taurus is in Gemini or because Mercury is aligned with the moon or what, but I do think there are good reasons to believe that the bulk of the equity market has been driven by what, 6, 7 companies. They make for 85% of the performance of the equity market since the beginning of the year. The real economy is very disconnected from the performance we see on the equity markets. And indeed, I don't think the liquidity crunches story or these financial accidents are behind us. So I would be very cautious and very selective with stock picking in the US equity market for the next 6 to 12 months. Yes.

And where would you prefer to put that stock money? What markets would you put that into?

Come to Europe. No, of course.

And you have to defend yourself against the accusation of people saying you're just saying this because you're European. So you must tell us what looks good about European markets and has your feeling about them changed over the years and does it look particularly attractive now?

Look, you know, 3 things. First, there is much less chutzpah than in the US. So somehow there is less overvaluation. I think the European stocks are fairly priced or priced in a fairer way than in the US. So somehow there are very interesting stock picking in green manufacturing, in luxury goods, in tech that I think are worth looking into. Secondly, the euro has appreciated quite strongly against the dollar. So, you know, maybe now is not the best if you want to cash out in dollar, but somehow I think this trend will continue. So I think for investments, it's, it's a place where you can have some form of added value also from the diversification of the currency in the current environment.

Ludwig mentioned a few other reasons he likes European stocks. He says even though there are many concerns in Europe, one big one being the current energy crisis, these concerns are different from the ones we have here in the US. There's not the same regional banking crisis, and Ludwig says the risk of a financial correction is looking lower. I also asked about bonds.

Bonds are back, you know, income is back. The bond market corrected massively last year. This was a once in a 30-year event when we had both the bond and the stock markets collapsing. There was nowhere to hide last year. So what we see right now in the bond market is very interesting. Income is back. Also, I think the bond market is a bit more resilient than the stock market. Volatility seems to be behind us because central banks have done the heavy lifting somehow. So there is a bit more forward visibility. I don't think they're done yet, Maybe the Fed is. I don't think the European Central Bank is, but somehow there is a bit more fundamentals kicking in in the bond market after policy decisions and upside surprises in inflation making for a bad financial vortex on the bond market. So I think there is good momentum in the bond market. Then credit risk is something that I would be careful in the bond market. So I would be Maybe not looking for too high returns, so I would be maybe shying away from some of the high yields and some of the fallen angels in the credit space. I would be focusing on good old government bonds and also investment-grade corporate bonds. And also I would be very selective on the sectors, again, you know, trying to go after sectors where I don't think there's going to be a propagation of the liquidity risk. So maybe away from real estate, for example. But bonds are very interesting. I mean, the pain last year was very strong, but now it's long-term gains for, you know, buy-and-hold type of strategies, for people that want to have some form of dividend payment or some regularity in their investment in something with a bit more forward visibility, maybe less returns. That's the long-term story of bond markets. But somehow the moment to invest now is very good in the US. Wait a little bit maybe for Europe, because we still have some tightening to do because inflation is a bit stickier. But certainly also very good time to look again at European bonds in the second half of this year.

For stocks, you prefer Europe to Japan, and what about emerging markets?

I prefer Europe to Japan because I think there is a strong case for monetary policy normalization in Japan. There is a bit this idea that nobody knows how Japan gets out of the zero negative interest rates, and somehow there could be some form of very strange equilibria forming in the Japanese stock market. They are somehow very domestic. There is a home bias that is very strong. So I don't think there will be a lot of volatility, but I would be concerned. And then emerging markets, there are 50 shades of emerging markets. I think I'm very impressed by the resilience of Latin America. Brazil, Mexico. I'm also very positively surprised by how determined central banks in the emerging world were to hike preventively to avoid a 2013 taper tantrum. And so they've been ahead of the curve in Eastern Europe, a bit late in Asia, but they're still very committed to hiking. And so somehow this is providing some good opportunities to invest in stocks in emerging markets where most of the companies listed are very strong companies, very diversified. So I'm still still quite positive and constructive on emerging markets, a bit maybe selective when it comes to how credible is their policy mix and how their politics will play out, especially when it comes to forming allegiances between the US and China, which I think is going to be a big discriminatory factor, I would say, for investors in the near future.

Can investors still make the kind of long-term returns that they're used to? Let's say that they're used to the stock market returning 10% a year on average over time and bonds, well, they've picked up, you know, more money as yields have fallen. Maybe that's not going to happen, but maybe they want to get at least the yield as a yearly return. So if you put them together, I don't know, call it 6% or 7% on a balanced portfolio. Is there any reason to believe that they won't be able to make returns like that going forward? Or can they do it so long as they stick, as you say, with the right markets where valuations are lower?

What is sure is that we are in a different world, right? With a bit more structural inflation from fragmentation and decarbonation and demographics, and maybe also from debt. So there is this expectation that returns will be also affected. I just mentioned decarbonation, for example, is basically the gravity of decarbonation calls for lower return on equity. For example, the fact that debt is more expensive also calls for for lower return on equities. For the longest time, most companies' return on equities have been driven by leverage. Now leverage is a bit more costly, right? Worries about volatility of returns. So I, I wouldn't say that we will enter in a phase of lower return structurally, but I sense that we have ahead of us a period with certainly more complicated returns. It wouldn't be as easy to make 6, 7% as it was during the past 20 years. It's still feasible, but I think it will require more work, more time, more advice, and certainly a bit more agility.

Thank you, Ludwig, and thank you, Oren and Wolfgang, for sending in your questions. I also want to thank the chicken and both Kevins, Bacon and House Speaker McCarthy. And please keep the questions coming. Just tape on your phone, use the voice memo app, and send it to jack.hough@barons.com. Thank you for listening. Meta Lutzoft is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. We'll see you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.