Here we go again. It seems like every few years America stands at the brink of a catastrophe. Politicians from the left and right are playing chicken again with America’s finances. After decades of spending by both parties, the same two parties are now arguing about how to pay their bills. And without a firm agreement, this argument is once again pushing America to the brink of financial ruin. The wrangling over the debt ceiling comes at a very sensitive time for markets. Banks are already in a world of pain due to higher interest rates. If we can’t get a deal down and interest rates shoot up, that could spell disaster for more banks. With no agreement in hand, President Biden has left for Asia to attend a G-7 meeting while his colleagues in Washington DC duke it out. (Quick quiz: How many G-7 countries have debt ceilings? The answer: none. There are no other developed countries on earth with such a restrictive debt ceiling).
America’s debt ceiling debate is a phenomenon that is of our own political making. For the past 100 years, politicians have looked past their ideologies and voted to keep America’s finances stable by increasing the debt ceiling almost a hundred times. But as the size of the deficit has ballooned, so has the partisan debate. Partisan rancor over the debt ceiling reached a new level back in 2011 when the Tea Party came to power. Since then our debt has worsened, almost doubling in the past decade (see below)!
During the 2011 debt debate, the Treasury did draw up a contingency plan in case a deal wasn’t made. That framework is a great way to frame today’s conversation. Under that plan the Treasury would make every attempt to avoid a technical default by continuing to pay interest on bonds. As bonds mature, the Treasury would pay off the principal by auctioning new securities for the same amount (thus not increasing the debt). They would delay payments on all other obligations (Social Security beneficiaries, Medicare providers, government employee salaries, departmental budgets, etc.) and prioritize whom to pay next. This prioritization of payments is likely going to face steep legal obstacles. It is hard to imagine that the Treasury has the legal authority to pay some bills and not others, especially since Congress has legally approved all of them. Surely the Treasury doesn’t have the line-item discretion. Of course, there’s other talk about minting a zillion-dollar coin or invoking the 14th Amendment. Both ideas are also in an extremely gray legal zone which is probably why they have been brushed aside by Treasury Secretary Janet Yellen. The Federal Reserve is also in a quandary. Having our central bank buy the defaulted securities of the government is similarly constitutionally questionable for the “lender of last resort”.
So far, the markets have taken the debt ceiling issues in stride. Over the past few months, stock and bond markets are noticeably less crazy than during the 2011 debt talks. Back then, stocks fell about 15% in a few short weeks. This time we haven’t seen a sharp selloff in stocks. In fact, the S&P 500 is actually up in the past few weeks. Bonds too; yields on the 10-year US Treasury have been relatively range bound. Either investors are optimistic that the politicians will get this worked out or there is too much complacency out there. As we get closer to the June 1st “x-date” we anticipate the markets will get more volatile. We continue to be very optimistic about the longer-term prospects for America and Americans. Any large decline in stocks could provide us with a nice entry into a few names we’ve been watching. After a deal was reached in 2011, stocks rose over 25% the following year.
U.S. markets continue to trend higher in the face of debt ceiling negotiations. Investors seem to be pricing in a rosy resolution to debt talks, which have been front-page the past couple of weeks. In the background, the Federal Reserve received more data about the American consumer on Tuesday. Retail figures showed consumers were back in force in April as opposed to March, spending more money online, dining out, and on home improvements. Perhaps it’s the summer weather, or maybe it’s the continually robust employment figures week after week. Needless to say, the current market environment is anything but vanilla. For the week, the S&P 500, Dow Jones Industrial Average, and Nasdaq are all up 1.71%, 0.81%, and 2.99%, respectively, as of today’s close.
Benjamin Lau, CFA
Chief Investment Officer & Principal