Saturday, October 12, 2013

Default: Nightmare on Wall St?



 

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. 
 
 
 I have to credit www.tradingeconomics.com for these graphs.  The site is a wealth of statistics and charts.
 
 

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