Nothing on the news this week seems to be encouraging. There is gridlock in Washington, and there are dire warnings of financial meltdown if the US defaults on it's debt. I am sure the memories of 2008 are still fresh in investor's minds, and on the whole they are terrified of going through that again just as many people have recovered their losses from the last correction.
As the debt ceiling showdown looms, I thought it would be a
good idea to look at the possible effects of a US default on the financial
markets- namely the US Stock markets. To do that, we can look at the last global debt default.
The last time a major world power defaulted on its debt was
Russia in 1998. The combination of the
Asian financial crisis and falling natural resource prices put the Russian
economy in dire straits. By August of
that year the Russian gov’t was no longer able to make good on its obligations. From January to August of 1998, the Russian
stock market declined about 75%. The
black line on the first chart below tracks the Russian stock market (the red
line is the Dow Jones, just for comparison).
There are two things I’d like to draw from the below
chart. The first is that Russia’s
default, and most other sovereign debt defaults, are the end result of some
other drastic economic effect. As you can
see below, the Russian markets were falling long before the actual default
later in 1998- serious trouble had surfaced before then. There were real economic and financial
reasons why the country was unable to pay its debt service, and eventually they
had to accept default. Our current
situation is nothing like that. Instead
of economic reasons, the only reason we would have a default is through a self-inflicted
wound due to the total failure of our government. It’s unclear how the markets would react to a
default with this unique set of circumstances.
After all, if a default were to occur, it would be surprising if it was
anything but very short. This fact alone
would make our “voluntary” default somewhat novel.
The other thing you can observe from the chart below, is
that the Russian markets did in fact recover.
It was not fun to be an investor there in 1998, however, two years later
in 2000 the markets had recovered, and then some. In fact, from 1998 to 2008, while the Dow
Jones made almost no gain, the Russian market would have grown by a factor of
at least four even AFTER the 08 crash (second chart). So in short, a default on sovereign debt, as
we have seen elsewhere, is temporarily disruptive, but in the long run not the
portfolio destroying event it is hyped up to be.
