by Olivier d'Assier
Another administration, another Congress, another looming deadline on the US debt ceiling.
As Qontigo’s Executive Director for Applied Research, Olivier d’Assier is responsible for generating unique insights into risk trends.
According to Treasury Secretary Janet Yellen, the US government will run out of money to pay its bills as soon as June 1. In this note we look at the potential downside risks of even a temporary ‘default’ by the US next month, stress-testing a series of portfolios using Axioma Risk tools.
In order to start appraising the problem of a default, we first look at history and see if this has happened before. The answer is ‘yes’ — in 2011. The similarity with today’s situation is uncanny. Back then, the new Republican majority in the House of Representatives demanded President Obama reduce the government’s deficit in exchange for raising the debt ceiling. On July 31 of that year, Democrats and Republicans in Congress agreed at the eleventh hour on a package of future spending cuts that increased the US government’s capacity to borrow money just two days before it would have exhausted. The only difference is that the Fed Funds rate then was at or near 0% and is now at 5%.
Between July 22 and Aug. 8, 2011, the US market declined by 16%. If we replay this history on a portfolio representing the global developed ex-US market (to determine the impact of the US decline on the rest of the world’s equity markets), we get a potential loss of 14% on today’s portfolio.
The same historical stress test on a portfolio of global emerging-markets stocks today yields a smaller potential loss of 9%. Looking at our well-diversified Multi-Asset Class Risk Monitor portfolio (from the MAC Risk Monitor), we get a smaller loss of -7%, as the fixed income portion would actually generate positive returns from a flight to safety. So, if history was to repeat itself, we could be in for substantial losses in our global portfolios.
Investor positioning
Because history doesn’t necessarily repeat itself but often rhymes, we then ran a series of transitive stress tests where we used today’s portfolio holdings, apply the 16% drop in US equities as a shock, and calibrated the correlations between US equities and the other assets in our portfolios to three different periods:
- the 60 trading days prior to the 2011 crisis
- the 60 days surrounding the crisis days
- the 60 days after the crisis ended.
We did this to find out if a) the crisis was a surprise to investors, and b) how quickly they got over it (or if correlations remained perturbed for a prolonged period after the resolution of the debt ceiling crisis on Aug. 9, 2011). The idea is that if results using the correlation around the crisis are significantly different than those using the correlations before or after, then we will know that the crisis came as a surprise to investors. And if the results of the post- and pre- periods match each other, we can assume that investors quickly returned to normal once the crisis was averted.
Results
For our global ex-US portfolio, the potential losses from a 16% downward shock to US equities using the pre-, during, and post-crisis correlation regimes were -11.5%, -10.6% and -11.2%, respectively. The smaller drawdown in the “during” period means that investors were caught off guard at first, quickly rebalanced their allocation to favor global ex-US markets during the crisis, then returned to their original allocation (back to US stocks) once the situation settled.
For our global emerging-markets portfolio, the potential losses using correlations were -6% before the crisis, -6.3% during the event and -4.9% after the resolution. This means that the crisis had little impact on global emerging-markets investors.
Finally, for our multi-asset class risk monitor portfolio, results were virtually unchanged across the three periods, at -6.7%, -6.9% and -7%, respectively, indicating that a well-diversified portfolio of 50% in equities, 40% in fixed income, 5% in currencies and 5% in commodities, seems insulated from another debt ceiling crisis.
One last question
So far, we have looked at the expected loss from replaying the 2011 history or using the correlation regimes from 2011 on today’s portfolios. In our final stress test, we asked what would happen to today’s portfolios of global ex-US equities if the US market were to fall by 16% again — this time using the current (YTD) correlation regime. In this case, the expected contagion would be just -5.4%. International equities seem much more immune to the risk of a US default in 2023 than in 2011.
Conclusion
The debt ceiling crisis is having a rerun at a theater near you. Should you worry about it? Although highly unlikely, it remains a plausibility that can easily be modeled in Axioma Risk. Using a series of historical and transitive stress tests on various portfolios, the results indicate that the impact of such an event can be severe but is likely to be temporary, with most portfolios reverting to their pre-crisis status relatively quickly.
That is not to say that all portfolios will recover their losses, but simply that losses purely associated with the changes in correlations between US equities and other assets in the portfolios will revert to their pre-crisis relationship. What mattered to the success of your portfolio then, will matter to its success post-crisis. In short, plus ça change, plus c’est la même chose (The more things change, the more they stay the same).
