Wall Street, wary but expectant, awaits debt ceiling deal from D.C.

The markets are counting on Washington to raise national debt ceiling by Aug. 2, but that's not all. Wall Street also expects a deal that cuts the size of US budget deficit. How much is it looking for?

Bebeto Matthews/AP
John Bowers of Bowers Securities makes trades using a handheld device on the floor of the New York Stock Exchange on July 22.

A US government default on national debt? That’s not what Wall Street is expecting.

While the debt ceiling negotiations continue in Washington, many Wall Street money managers simply don’t believe that Uncle Sam will not meet his obligations. Yes, the dragged-out drama may produce some sweaty palms in America's financial capital and stocks may have moments of weakness – as they did Friday, when a skittish Dow Jones Industrial Average was down about 30 points at midafternoon. But the notion that the US Treasury would not pay its bills after Aug. 2 is almost inconceivable to Wall Street.

In Congress, “they may go to the 11th hour, 59th minute, 59th second, and they probably will, because that is the way the system works,” says David Kotok, chairman of the money management firm Cumberland Advisors in Vineland, N.J. “But we are not going to have government default.”

The “no default” crowd is the “consensus view” among financial movers and shakers, says Pete Davis, who advises Wall Street firms on the ins and outs of Washington politics. However, he says, “When you talk about all the details [of a prospective debt-deficit deal] – which are pretty problematic, unresolved, and contradictory – it becomes a lot less clear.”

The details may be unclear, but many money managers say they can predict how it will all turn out.

Typical is Jeffrey Kleintop, chief market strategist at LPL Financial in Boston. His firm’s “base case” is for the Congress and President Obama to agree to reduce the US budget deficit by $1 trillion to $2 trillion over the next 10 years, says Mr. Kleintop. “They don’t address entitlements or any tax increases but kick those down the road to the next election.”

Congress and Mr. Obama can’t kick the can down the road too far because on Thursday Standard & Poor’s, the debt rating agency, said it will lower the US government’s AAA rating unless lawmakers, in addition to simply raising the debt ceiling, make a “credible” effort to reduce the size of the US budget deficit. S&P says the odds of the US getting its top-rank rating lowered are 50-50. Any reduction in the US government’s debt rating would be expensive: Mr. Davis estimates it would cost taxpayers about $64 billion more a year in interest payments.

That’s one reason Mr. Kleintop would like to see Congress tackle the cost of entitlement programs, such as Medicare and Social Security. “A $1 trillion to $2 trillion cut won’t do it,” he says.

However, whether the government will default is the No. 1 question being asked by the firm’s advisers in the field and its clients, he says.

“We’re telling them it’s in no one’s interest to default,” Kleintop says.

Doug Roberts, director of research at Channel Capital Research in Shrewsbury, N.J., says it’s possible that the Treasury could go into “technical default,” but he reasons that, within days of a default, some kind of measure will clear Congress that will “kick the can down the road” but allow the national debt ceiling to rise.

Mr. Roberts, who sees the whole issue as one of pure politics, envisions a 10-month solution that will need to be readdressed right before the 2012 election. “My thesis is that they [in Congress] are reelection mode,” he says.

Despite his expectation that Washington will muddle through the crisis, Roberts says he has kept his accounts in more cash than is usual. He has also moved some investors into gold, a commodity for which prices have been rising as the news ebbs and flows from Washington. The price was up more than $14 per troy ounce, to $1,601, by midafternoon Friday. “The real danger is they do something stupid with the debt,” he says.

Kleintop, too, is hedging his bets somewhat by putting some investments in gold. He reasons that if Congress and the president fail to reach an agreement on the debt ceiling, stocks would fall by 20 percent, the world economy would go into a recession, and the value of the dollar would plunge. “The only safe haven is gold,” he says.

However, he is optimistic that a solution will be reached on the debt ceiling and says he has started to invest some of his clients' cash back into the stock market.

“Earnings are solid, and the soft spot in the economy seems to be getting better,” he says. “Now is the time to move back into the market but recognize there are some risks.”

Mr. Kotok at Cumberland Advisors is even more willing to back up his words. He’s now buying stocks of financial companies, such as banks, even though their prices have dropped because of uncertainty surrounding the debt crisis in Washington. Many banks invest in Treasury bills, so any downgrade of the US credit rating would adversely affect the banks’ portfolios.

Once the debt ceiling crisis is resolved, Kotok expects the stock market to rise. “We are in an inflection point of major proportions,” he says. “The markets are being burdened by default risk, and the economy is growing slowly because of default risk.” After that risk is resolved, both will start to grow, he says.

Even Davis, who advises Wall Street clients, can’t imagine the US defaulting or losing its AAA bond rating.

“I think they are going to get to edge of the cliff and decide to do something,” he reasons. “Maybe they will make a deal to cut $1 trillion [in spending over time] with a promise of trillions more cuts after a commission does a report,” he suggests. However, any solution that includes tax reform will be more problematic, because any changes could create a lot of losers.

“That means half [of taxpayers] have increases and half have cuts,” he says. “That does not sound like a politically viable solution.”

However, time is starting to run out. Davis, who was previously a congressional staffer, says it may be possible for the House to “cram through legislation if the leadership wants to.” But, the Senate is a different proposition, he says. “In the Senate, passing the Ten Commandments would be hard to do in a week."

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