As the debt limit is breached, investors should take caution
Lawmakers in Washington, D.C., have made little progress in negotiating an increase to the debt ceiling since the U.S. government officially reached its debt limit on January 19. While the Treasury Department has been implementing so-called extraordinary measures since that time—drawing down on its existing cash balance and invoking various measures to allow it to continue borrowing—time is quickly running out.
In fact, on May 1, Treasury Secretary Janet Yellen notified Congress that the federal government could default on its debt as early as June 1 if legislators don’t raise or suspend the debt ceiling.
To gain clearer insight on the policy developments in Washington, we leverage a network of leading political strategists. Across our network, the consensus is that cooler heads will ultimately prevail, and a deal will be reached, though perhaps not until the eleventh hour—we could even see a partial government shutdown if the debate is protracted. Ultimately, the process is likely to be messy and painful, creating further volatility across markets.
The political backdrop increases the risk of a default
Compared to prior negotiations, the odds of failing to reach a deal before the deadline are elevated for several reasons. First, razor-thin margins in Congress are resulting in a more protracted showdown in Washington. Lawmakers on both sides of the aisle are digging in, with Democrats calling for a “clean” debt ceiling increase with no spending cuts and Republicans making it clear a deal must come with spending reductions. A meeting between President Biden and congressional leaders on May 9 produced little movement on the issue, but did secure plans for further negotiations.
Rising interest rates further complicate the issue, with the U.S. fiscal situation deteriorating as interest costs increase. In fact, U.S. debt servicing costs now sit at their highest level since August 1999, per government budget data just released in April. In addition, tax revenue has declined, with April tax revenues coming in $200 billion below the Congressional Budget Office’s end-of-fiscal-year forecast.1 Together, these factors have made raising the debt ceiling even more urgent.
“A U.S. default is not the most likely outcome, but we can't rule out Treasury resorting to unprecedented measures to prevent it, steps that could rattle financial markets and negatively impact the economy.” —Oxford Economics
“We still believe that this will ultimately get resolved and there will not be a default ... we believe the most likely outcome is some kind of 11th-hour Congressional deal resulting from frenzied negotiations after markets start to show signs of strain.”
Looking back at history
Though the debt limit has been increased over 100 times since World War II—most recently in 2021—increasing it has become more contentious in recent years given conservative Republicans’ focus on fiscal austerity. Our political strategists point to the wrangling in the first term of the Obama administration, in 2011, as the closest analog to today given the political dynamics. Then, the bulk of the debt ceiling debate similarly occurred over the summer—with a resolution in August—but not without significant market volatility along the way. In fact, bond yields fell by 200 basis points (bps) from a peak of 3.72% in February 2011 to 1.72% in September 2011.2
While somewhat counterintuitive (one might think that bond values should fall—and yields rise—as fears of a default pick up), the bid for bonds was likely a function of investors managing risk amid the uncertainty created as the debate around the debt ceiling persisted. Yields might have also been affected by the sovereign debt crisis in Europe, another event that sparked a risk-off stance among investors. Lastly, it’s generally true that longer-term bond yields tend to fall in an environment where the Composite Index of Leading Indicators (LEI) is decelerating, which was the case in 2011. Stocks also declined during this timeframe, with the S&P 500 Index seeing a price decline of nearly 20% from May 2011 to October 2011. The debt ceiling was ultimately raised on August 1 and U.S. debt was downgraded soon thereafter on August 5. The S&P 500 Index took roughly five months to recover to the prior high.3
Investors would be wise to exercise caution
Though there are several differences between 2011 and the current economic and political backdrop, history can be useful in helping us discern a possible range of outcomes and suggests that the risk of another debt ceiling crisis is something to be mindful of. Adding to our caution, we have the LEI already in deeply negative territory (signaling a pending recession) at the same time that the U.S. Federal Reserve just implemented the most aggressive tightening cycle since 1980, the lagging impact of which is causing credit conditions to tighten and economic activity to slow. If political risk around the debt ceiling intensifies, it could be another reason for investors to favor high-quality bonds and be patient before reaching for risk in the equity markets.
In our view, these risks aren’t currently being priced into markets. The price-to-earnings ratio on the S&P 500 Index is elevated at 18x forward earnings, the Cboe Volatility Index—a measure of market volatility—is still well contained at under 20, and high-yield bond spreads are under 500bps, which is below their 20-year average.3 Risk assets are pricing in a timely resolution to the debt ceiling issue, which we believe is the most likely outcome—but the chances of a default are higher than zero. We see high-quality/defensive stocks and high-quality bonds as one of the best ways to ride out what could be a challenging period for markets.
1 Strategas Research Partners, May 2023. 2 U.S. Department of the Treasury, as of May 12, 2023. 3 Bloomberg, as of May 12, 2023.
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