Why you should be prepared for the US to go bust

You've probably read news reports about the US government shutdown.

800,000 US public sector employees are no longer working. So if you're about to go on holiday in the Yosemite National Park, you need to come up with a Plan B.

But beyond that, does it really matter? After all, there have been similar shutdowns in the past. None has inflicted any lasting damage.

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I'd say you'd be right to be cynical if the shutdown was the only problem.

Trouble is, the US government is also about to hit its debt ceiling.' And if Congress refuses to raise that ceiling, the consequences could be a lot more serious.

In fact, I think we could be at the start of a very bumpy ride it's time to buckle up

Why the debt ceiling is more important than the shutdown

Before I go any further, let's just clarify the difference between the shutdown and the debt ceiling.

The shutdown has come about because Congress hasn't given the government the authority to spend money on non-essential services. So that includes parks, visa processing and crackdowns on tax evaders.

Similar shutdowns have happened before. The last one was in 1995/96, under Bill Clinton.

And while they make for grim-looking politics, you couldn't say that any shutdown has been a disaster for the economy. It's estimated that the last shutdown knocked about 1% off US economic growth that year significant, but not catastrophic by any means.

The debt ceiling issue, however, is more serious.

The ceiling is the maximum amount the government is allowed to borrow to fund its various obligations. Now let's be clear this is a legal construct. It's entirely artificial. There is no genuine ceiling on what any government can borrow, beyond what the market is willing to lend at that moment in time.

But it still matters. Here's why.

The ceiling is set by Congress. If US politicians are willing to raise the ceiling by the middle of this month, there's nothing to worry about.

But if the ceiling isn't raised, the government will be in a mess. Legally speaking, it won't be able to borrow money issue US Treasuries to fund its spending. Therefore, it will struggle to pay welfare benefits, or to fund various government programmes.

Companies that are very reliant on the US government, such as Boeing and Lockheed Martin, could be especially hard hit. And if government employees and those on welfare aren't getting any money, it could hit spending and growth hard.

An even bigger deal for markets is that the US might default on its government bonds.

You see, if the government can't issue more bonds, that means it won't be able to roll over' bonds that are maturing. So holders of Treasuries might ask for their money back, only to be told they can't have it. The government might even fail to pay some interest payments on its debt.

A US default could trigger a financial panic

So what would the impact be? No one knows for sure what would happen if the US were to default. It's never happened before.

But we can be fairly confident that the status of US Treasuries as a risk-free' asset would be damaged. That's a problem, because US Treasuries are effectively the benchmark' asset for almost every other market.

If you drive up the yield on the least-risky asset in the market, it stands to reason that yields on other assets have to go up too. In turn, that could drive up borrowing costs for everyone from the government, to businesses, to individuals. It would also be bad news for share prices.

Banks are likely to be particularly vulnerable, as Treasuries often comprise a big slug of their low-risk capital assets.

At the very worst, we could see a financial panic similar to 2008.

Now, to be absolutely clear, I'm not suggesting that we're definitely going to see an apocalyptic debt ceiling' crisis in three weeks' time.

For a start, you'd expect politicians to come up with a last minute deal to raise the debt ceiling. That remains the most likely outcome. Also, I suspect there's enough slack in the system to find money to keep bondholders happy for at least a short while beyond the deadline.

However, one of the keys to smart investing is looking at the balance of risk and reward. If markets had plunged in recent weeks, I might be telling you to buy now. But as it is, investors are way too blas for my liking.

A nasty outcome is possible here. Regardless of your own political leanings, it's clear that the Republicans are a party in turmoil, with a lot of loose cannons rolling around. And Obamacare' is an issue on which neither side seems willing to compromise.

So it is at least possible that Congress will refuse to raise the ceiling. And the market is not pricing that in.

Crazy options for a crazy outcome

If the debt ceiling isn't raised, Obama has a couple of unconventional options. One is to create a trillion-dollar platinum coin that could be used to meet the government's financial obligations.

I know, I know, it sounds completely crazy. But it would mean the government could spend extra cash without breaching the debt ceiling. (You can read more about it here.)

Or Obama could argue that the 14th amendment of the US constitution gives the government the power to issue bonds without congressional approval. But this could just create a legal stand-off that would be unsettling for financial markets.

And this is the real problem with either of these options. If things get so desperate that the US is considering radical moves like minting a trillion-dollar coin, markets are not going to like it one bit.

So my point is this: it's possible that we'll see a debt ceiling crisis later this month. My gut feeling is there a one in three chance the ceiling won't be raised.

Make sure you keep some powder dry

So what should you do? Don't panic. Stick with your long-term investments. The US market looks pretty overvalued just now, but the ones we've been recommending that you buy Japan, Italy, various emerging markets - don't.

But make sure you have some cash to hand. If you have taken any more speculative punts recently, it might be worth locking in some profits on them. The ceiling may be raised, and this will all blow over. In that case, no harm done.

However, if the ceiling isn't raised, markets everywhere will take a hit. That could throw up some very attractive opportunities - there might even be the chance to pick up a bargain or two in the US. You want to be in a position to take advantage.

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