Sweet Dream May Turn Into a Nightmare

Published by Filipe R. Costa on Tue, 15/01/2013 - 11:14 in

Daily Market Commentary for January 15: This year has been great for equities so far as pointed by S&P 500 and FTSE 100 which are up 3.2% and 3.8% respectively, but sentiment may be changing as the US debt ceiling debate starts.

Do you remember what happened in August 2011? Instead of a silent and calm August spent with family at the best beaches under a warm sun, investors had to connect their notebooks and try to sell as fast as they could all their investments as the market sank due to never-ending negotiations in US Congress concerning the debt ceiling. The dead-lock resulted in the US credit rating being downgraded and in volatility rising to values not seen in decades. Republicans and Democrats played games until last minute and then avoided the worst, a default by the US government on its debt obligations, but couldn’t avoid the turmoil. Is history to repeat this year? Obama is playing it hard, trying to put some pressure on Congress but history tells us that Reps and Dems are willing to play their way until last minute, such that volatility may rise. I personally don’t believe we will assist to the same kind of movements we saw in August 2011, but if I had long positions, I would buy some put options to insure my portfolio and it certainly isn’t the time to open new ones. The US Treasury is at the $16.4 trillion limit and won’t be able to issue more debt. From now until mid February they can manage their obligations but from that point they will default if nothing is done. The clock is ticking once again.

In Europe things seem a little brighter than in the US. For the first time in a few years we are hearing the same from all voices and that is “the worst of the crisis is already behind us”. Regarding that being true, I cast my doubts. With many economies expecting negative GDP growth and unemployment around 20%, I doubt the worst is gone. It is true yields on indebted countries are now much lower. Portugal, for example, would have to pay 6.2% to place a 10-year bond in the market at this time, after seeing yelds largely surpassing 10% a few months ago. But, it is also true, yields on countries as Germany, UK, France, just to name a few are too low for their current debt levels (probably with exception of Germany). When this bubble burst, bond prices will drop and stock prices will have to follow the same route. But for now, we just have roses and sweet dreams...