Credit Suisse: "Debt Ceiling Hike Delay: Market Down 15%; Default: Market Down 30%+"

In the past week, almost every single sellside bank and their mother has released a report on "what happens to the US if there is a [default|debt extension|compromise|zombie apocalypse (if one believes Tim Geithner)]. Sure enough, here is Credit Suisse with its three scenarios. This is notable as it presents the binary outcomes for the stock markets as a result of what develops in Congress. The scenarios are: i) debt ceiling extension (market up 3%); ii) debt ceiling not extended (market down 15%); iii) default (market plummets by at least 30%). Of course, if there is really is a default it is game over for equity markets but that is a moot point. Either way, any report that has zero mention of the word gold when contemplating the impact of a US default goes straight into the garbage. Such as this one.

Here is Credit Suisse's scenario summary :

And a brief and largely irrelevant summary of the key outcomes.

What happened during the previous debt ceiling crisis?


We have already had a debt ceiling crisis between November 15, 1995 and 29 March 1997 (with two short episodes of government shutdown, in November 1995 and December 1995 to January 1996), when  the Republican party agreed on raising the ceiling to $5.5trn after Secretary Rubin informed Congress that he would stop mailing out Social Security cheques. During those periods bonds yields, the dollar and the S&P all rose a bit.


The difference this time around is that the US is running a budget deficit of 11% of GDP, not of 2% of GDP. Hence, the required fiscal tightening to balance the books if the debt ceiling is not raised is a lot higher. Moreover, this time there is also more fiscal tightening on at the state and local level. [as we presented yesterday]

On to the market impact of the various outcomes:

No debt ceiling agreement: equities markets down 15%


If there is no increase in the debt ceiling for a prolonged period (say 3 months) with no agreement in sight, we believe stock markets could easily fall 15%. As above, we believe we get very close to recession – and if say ISM fell to 40 and credit spreads rose to 4%, the warranted equity risk premium would rise to 5.8%. At the same time, EPS on our model could fall 15%, leading to equity risk premium to fall 5%. This would give equity markets some 12% downside.


We believe that the fall in markets would give politicians a strong incentive to compromise – and we would likely get an agreement (as it was the case with TARP, when the first rejection of the bill on 29th September 2008 triggered a 9% fall in markets and the bill was then passed in a second vote on October 3rd).


In Europe, this would happen at a time when the long-term bank funding market is still almost closed, recent PMIs have been particularly weak (suggesting GDP of just 0.2% quarter on quarter). We believe this makes Europe more vulnerable than normal, especially if the Euro, as seems likely, would strengthen a lot in this scenario. Clearly, weaker global growth and a generalized risk-off trade would make funding issues in peripheral Europe worse.


Overall, we would expect the sharp decline in growth expectations to lead to lower bond yields, as the impact of weaker growth more than offsets investors’ concerns about the credit downgrade. On our fair value bond model, each 10 points decline in the ISM reduces the fair value of bonds by 75bps. In this case, investors should focus on secular growth (as it is long duration and benefits from the fall in the discount rate) and noncyclicality (healthcare, telecoms, food retailing, regulated utilities). In addition, we would greatly increase our underweight of cyclicals and with the exception of software (which should prove defensive as in 2007/8). In particular, we would go short of corporate spending related areas, given that corporate spending is typically the high-beta component of growth.


The sectors that have low cyclicality (negative correlation with the ISM) and low leverage (net debt to EBITDA) are pharma, health care equipment, food retailers and software.


In case of default, just be overweight defensives [ZH advice: in case of default, run]


If there was a default, we would simply focus on non-cyclical companies with high FCF yield and low leverage (as we assume that funding markets would dry up and the cost of debt would rise).


Focus on companies safer than governments


Regardless of the outcome of the negotiations over the debt ceiling, we think investors should focus on ultra-safe corporates (those that offer a CDS spread below that of the average G7 sovereign in combination with a dividend yield above the average G7 government bond yield). To the extent that the debt ceiling negotiation in the US and the worries about peripheral Europe drive home the uncertain outlook for government  finances, the strong financial position of these corporates will appear increasingly attractive.



Our US screen highlights Pfizer, Merck, Kraft and Philip Morris.


And more drivel in the full worthless report which according to a simple word search mentions the word gold precisely zero times.