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Analysis: Buy the dips, even if it's a dip on default

Traders work in the 10 Year Treasury Bill Options Pit at the Chicago Mercantile Exchange
Traders work in the 10 Year Treasury Bill Options Pit at the Chicago Mercantile Exchange

By Edward Krudy

NEW YORK (Reuters) - This is a story that was never supposed to be written -- the one in which investors draw up strategies for a government default.

But the prospect of such an unprecedented event that promises to roil markets has strategists scrambling to do just that. However, they are falling back on an oft-repeated maxim: Don't panic.

Despite dire predictions of what would happen if a deal to raise the U.S. debt ceiling was not reached over the weekend, equities were quite resilient on Monday, as the S&P fell just 0.56 percent.

Many still believe even a short-term default would be quickly resolved with little disruption to the economy. Strategists and large investors see any short-term market sell-off once the August 2 deadline for raising the U.S. debt ceiling hits as a buying opportunity in both stocks and bonds.

"People are screaming that the market is unbelievably complacent in the face of this massive U.S. debt ceiling risk," said David Bianco, chief U.S. equity strategist at Bank of America Merrill Lynch, who had just finished a call with clients perplexed at the markets' reaction.

But Bianco is more confident. He sees most scenarios as buying opportunities, running from a stop-gap solution that assuages ratings agencies to one that involves no deal and a downgrade. The main difference, he said, will be the magnitude of the correction before markets recover.

Bianco sees equities rallying as earnings remain strong and because investors are already discounting substantial risks to stocks. He thinks a sudden downgrade to double-A would cause a sell-off to about 1250 for the S&P 500 <.SPX> before a rally takes it to between 1,400 and 1,500 by year-end.

Until a resolution is found, Bianco recommends investors underweight the financial sector and rotate into cyclical sectors like technology and energy. That's a position that would be unwound going into the end of the year.

"The position that we are advising is a combination of sector positioning," said Bianco. "Our preference is for tech and energy and our area for sourcing capital for that trade would be from financials."

BOND DEFAULT? BUY BONDS!

Somewhat counterintuitively, David Joy, chief market strategist at Ameriprise Financial, believes U.S. Treasury debt could even rally as investors try to get out of the way of the unforeseen consequences in a so-called "flight to safety."

"It is something we've been talking about and it's one of the reasons why we're not making any big changes because there could be a rally in Treasuries, somewhat ironically," said Joy, who helps oversee $571 billion in assets.

The lack of clarity has many investors taking a wait-and-see approach. They are holding off making big moves for the time being but are ready to pounce if the need arises.

Ameriprise's Joy has been advising clients worried about a default to raise cash at the margins, as well as increase exposure to gold and other hard assets, which would do well if the dollar were to weaken further. But he does not believe investors should liquidate equity positions.

Joy believes a sharp pullback in stocks could provide a buying opportunity as long as any decline is not a result of an actual default, which he believes could weigh on markets for many months. He also counsels against jumping on a small dip that results from a half-hearted agreement.

"If there was a really severe downdraft in response to what comes out of Washington, I would say, 'Yes, in the long run it would represent a buying opportunity.' But if it's just a pullback in response to disappointment, that could linger over the market for a while," he said.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, who oversees $55 billion in assets, has boosted his odds on an actual government default to 20 percent from 5 percent. For him, it would represent a buying opportunity.

"It's not worth changing our longer-term course of action to address this and if the chips fall where they may and the market drops, we'll use it as an opportunity to add risk," he said.

For those worried about being in U.S. assets, he suggests increasing commodity exposure, such as gold, and putting money into Swiss or Japanese government bonds. However, he warns that gold, which hit an all-time high on Monday of $1,622.49 an ounce, could underperform in the event a deal is reached.

If Washington's shenanigans are more than empty threats and the government does actually default, fund managers can expect to spend their vacations consoling worried clients, much as some did after the failed vote to pass TARP legislation in September 2008.

"I've on more than one occasion spent the entire vacation doing conference calls and client calls," said Joy. "I hope this isn't a repeat of that."

(Editing by Dan Grebler)

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