Market Update: Debt Ceiling
With tax season behind us, the big financial news coming from Washington, D.C. now is about the debt ceiling. Here we’ll talk about what’s going on, what could happen, and what it means for your portfolio.
Congress authorizes various forms of spending through the legislation it passes. When income (primarily tax receipts) is not sufficient to cover the expenses to which Congress has already committed, the difference must be borrowed. This borrowing increases the national debt and brings us closer to the debt ceiling.
The debt ceiling was originally created to facilitate borrowing for U.S. participation in the two World Wars. The U.S. is one of only two democratic countries in the world to limit borrowing in this manner (the other being Denmark). The U.S. debt ceiling has been raised 78 times since 1960, or once every 9-10 months on average.
Refusing to raise the debt ceiling doesn’t reduce spending. It’s like swiping your credit card all month, and then refusing to pay that credit card bill. In theory that will limit your ability to use your credit card the following month, but the best way to manage your spending is by carefully limiting how you use your credit card in the first place.
We don’t know when government spending will hit the debt ceiling. Technically, we hit the limit back in January. But the Treasury has been able to use what they call “extraordinary measures” – accounting moves and pausing non-urgent reinvestments – to delay an actual default. We don’t know when these measures will run out, because that depends on revenue (the taxes we pay) and expenses that are variable and impossible to precisely predict.
If the debt ceiling is not increased, the federal government won’t be able to meet all its current obligations and would have to prioritize among things like federal employee salaries, Social Security benefits to retirees, and principal and interest payments on outstanding debt. It’s this last issue that has the potential to disrupt financial markets. If the federal government can’t make required payments on its debt, then it has defaulted, just like if you stopped paying your mortgage. This is important because US government debt is seen as one of the safest investments possible. Not paying on that debt could result in a debt downgrade for the U.S. government and higher borrowing costs.
We hope and expect that if things got this far, the political and economic fallout would be so swift and severe that the debt ceiling would then be lifted. If this became a protracted problem, it could hamper economic activity and contribute to a potential recession. This could also damage business and financial market confidence, but it’s difficult to estimate the exact impact because the situation would be unprecedented.
The last time we came this close to defaulting was 2011. The S&P 500 fell by over 10% but ended the year almost flat – and earned a double digit gain the following year. So those who sold during the turmoil were not rewarded. In the bond market, despite the increased prospects of not being paid back, intermediate- and long-term US Treasury bonds actually saw a positive return. While this history is instructive, it’s no guarantee that things will turn out the same way again.
But what does all this mean for your portfolio? As always, you should match investment risk to your timeframe, tune out the media noise (after all, they sell advertising space, not financial advice), and stay calm (being “greedy when others are fearful,” as Warren Buffet has famously said). We will continue to monitor developments in Washington, D.C. as well as in capital markets, and you’ll hear from us again if we think any significant changes are warranted or prudent.
We understand that uncertainty is always stressful, so as always, please don’t hesitate to contact any member of the team.
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