Wall Street: Main bout debt limit, not shutdown

Adam Shell | USA TODAY

NEW YORK — As fights go, Wall Street views the slugfest between Democrats and Republicans over the government shutdown as the undercard event. The main bout is the coming showdown over raising the debt ceiling and making sure the U.S. has enough cash to pay its bills and avoid the unthinkable: defaulting on its debt.

"The shutdown is a sideshow," says Brian Belski, chief investment strategist at BMO Capital Markets. "It's all about the debt ceiling and potential default."

There's a big difference between the hit to confidence and the economy due to the government temporarily closing for business, and the more serious threat of putting the full faith and credit of the USA at risk.

On Thursday, which marked Day 3 of the government's partial shutdown, volatility in the stock market began to rise. The Dow Jones industrial average fell more than 180 points before finishing down 137 points and below 15,000. Fears of a drawn-out fight over the shutdown have shifted to worries that Congress won't agree to bump up the nation's borrowing limit in time to avert disaster. The U.S. Treasury said it will be virtually out of cash on Oct. 17.

Still, there's a belief on Wall Street that the consequences of the U.S. not meeting its financial obligations would be so devastating to the economy and markets that there's virtually no way Congress will allow the first-ever U.S. default.

The U.S. not making timely interest and principal payments to holders of U.S. government debt is "the single most bearish scenario," says Adam Parker, chief U.S. equity strategist at Morgan Stanley. And Congress knows that.

"There is a 0% chance that the U.S. will default," Parker says.

The reason is simple: The financial fallout in the summer of 2011 is a deterrent of sorts, as Congress doesn't want to see that horror movie again. In August 2011, a last-hour Congressional vote to raise the debt ceiling was too little too late, and resulted in the U.S. getting its triple-A credit rating downgraded and intensifying a stock sell-off that knocked the Standard & Poor's index down almost 20%.

The U.S. Treasury warned Thursday that a default "has the potential to be catastrophic." It said it could spark a financial crisis and recession that "could echo the events of 2008 or worse."

Joseph LaVorgna, chief U.S. economist at Deutsche Bank, agrees with the Treasury's assessment, even though he, too, says the risk of default is "effectively zero."

"A default would be a 10 on the Richter Scale," says LaVorgna.

LaVorgna says the bad memories of the 2008 financial crisis are causing the market to get "nervous" as the political dysfunction drags on.

David Bianco, chief U.S. equity strategist at Deutsche Bank, says it would be "lights out" for the stock market if the U.S. defaults. Even if the U.S. briefly missed payments unrelated to its bonds, the market could fall 10% to 15%. And if interest payments are missed? "It will result in the worst bear market in U.S. history," Bianco warns.

The upshot: Markets will likely rally sharply once the period of political dysfunction ends, says Belski, noting that U.S. companies are in great shape relative to the rest of the world and will be helped by improving economies around the globe.