Deutsche Bank: Don’t Sweat the Debt Ceiling

Wall Street is certainly weary of the haggling in Washington over the nation’s debt ceiling and spending habits. But Deutsche Bank’s (NYSE:DB) top U.S. analysts say it could actually be a buying opportunity.

The trading community didn’t get much of a chance to enjoy New Year’s 2013 festivities, with Congress literally waiting to the last second, and then some, to pass legislation to avert the fiscal cliff. The move ignited a big rally that sent the U.S. market surging to five-year highs. But it also set the stage for a lot more fighting on Capitol Hill.

The deal left two big issues unaddressed: the sequester and the debt limit. The former is a series of arbitrary spending cuts to defense and non-defense programs aimed at slashing the federal deficit by $1.2 trillion through 2021. It was initially set to be triggered in early January, but was pushed back to March as part of the fiscal deal.

If either an agreement can’t be forged, or a deal involves big spending cuts, it could lead to a situation called fiscal drag. That is to say a big negative shock to government spending is likely to chomp away at   U.S. gross domestic product. As it is, the economy grew at a fairly sluggish pace of 3.1% in the third quarter, according to the Commerce Department. Deutsche forecasts expansion to have slowed down to 1.3% by the fourth quarter and then speed up slightly to 1.5% in the first three months of 2013.

The government’s actions, or lack thereof, are beginning to hit the economy already. The fiscal cliff deal failed to extend the payroll tax holiday, meaning every American making an income started seeing a smaller paycheck this month.

Joseph LaVorgna, Deutsche Bank’s chief U.S. economist, said at a press conference at the German    bank’s U.S. headquarters on Wall Street that the effects are difficult to exactly quantify. However, he reckons disposable incomes will likely take a $120 billion hit.

The scarier specter for trading desks is the debt ceiling. The U.S. has already technically hit its borrowing limit, which has forced the Treasury Department to take what it calls “extraordinary measures” to fund government activities. That is because the government pays for a large portion of its expenses through borrowing, since spending exceeds tax revenues.

In fact, as of Monday, U.S. public debt stood at $16.4 trillion, $11.6 trillion of which was held by the public, according to Treasury. If the $16.394 trillion debt limit isn’t raised, Treasury will literally run out of money to pay its bills. Economists expect that day to come around February or March (Deutsche sees it happening in early March).

The consequences of not hiking the limit could be disastrous. The government eventually wouldn’t be able to pay active-service military members, Social Security beneficiaries, Medicare recipients, among a slew of other obligations. However, the biggest hit from a financial perspective would likely be if the U.S. missed an interest payment on its bonds.

Issuing Treasury bills and notes is the way the U.S. borrows on public markets. Treasury bonds are seen as some of the safest investments money can buy. That’s part of the reason why the government only has to pay a yield of 1.855% to borrow for a decade.

If the U.S. missed an interest payment, however, it would be tantamount to a default – an unprecedented event for America. Many economists believe such an event would spark a financial crisis far worse than the collapse of Lehman Brothers that nearly toppled the financial system.

The thought that Congress is tasked with avoiding such an event is downright frightening. But Deutsche’s top U.S. equity strategist, David Bianco, thinks it may actually be a buying opportunity.

He said at the press conference in New York that recent history has shown that it makes sense to “buy the calendar-date risk.” That is to say market participants tend to get skittish leading up to specific dates when certain items will be triggered, leading to intense short-run volatility, but usually followed by big rallies.

For example, fiscal cliff fears sent the broad S&P 500 tumbling close to 3% in a year-end rout last year. The CBOE’s VIX, seen as Wall Street’s fear gauge, surged 31.5% during that selloff. However, after the New Year’s deal was announced, the S&P 500 soared 4.6% in its best week since December 2011. The VIX, meanwhile, has plunged some 36% since its recent highs.

The same general model could have been applied to the last debt ceiling debate during the summer of 2011. The markets crumbled as the U.S. came to the brink of default and saw Standard & Poor’s yank away its pristine “AAA” credit rating. However, Wall Street made up for lost ground and started climbing again in about a six-month timeframe. While a six-month recovery isn’t short, it is shallow compared to longer-term crises not triggered by calendar-date events.

Still, Bianco said the debt debate is likely to limit the S&P 500 to the 1500 range for the time being. His year-end target is 1575. He recommended being cautious about defense and health-care stocks for the time being, because they would likely be the first hit by any potential spending cuts.

LaVorgna echoed Bianco’s cautiously optimistic sentiment, questioning whether “we’ve gotten too pessimistic” about Congress. He said there could actually be an upside risk that Congress does actually manage to cobble together a deal and at least temporarily halt the acrimony that has been a Beltway hallmark recently.