Default or not, 2011’s debt ceiling battle is instructive for today’s investors

No time to lose in the current debt ceiling dispute

The current conflict escalated in January 2023, when the government officially reached its approved debt limit, leading U.S. Treasury Secretary Janet Yellen to implement extraordinary cash management measures enabling the government to continue borrowing while drawing down its remaining cash balance.

It had been previously expected that the Department of the Treasury could continue taking these measures until July or August without falling behind on obligations and breaching the current debt ceiling of approximately $31.4 trillion. However, Secretary Yellen warned lawmakers on May 1 that the timeline had compressed further as a result of recent tax inflow and expense outflow trends. In a letter to congressional leaders, she said the government might run out of cash as soon as June 1 “if Congress does not raise or suspend the debt limit before that time,” while noting the possibility that the actual date could be “a number of weeks later” depending on late spring tax receipts versus outlays.

This predicament has been driven by high levels of fiscal spending accentuated by outsize pandemic stimulus in the wake of COVID-19 and, in our opinion, a recent decline in tax receipts has worsened the short-term outlook. This revenue is highly dependent on taxable capital gains from interest-rate-sensitive assets, and many of these assets sustained investment losses amid the broad-based asset price declines of 2022.  

How do debt ceiling battles create the risk of government default?

In assessing government budgeting in general, spending has outpaced tax receipts in most years, while government debt has had to fill the gap, leading to the increase in national debt levels. Although debt and spending can be combined in any legislation, we must note that these are separate issues, as raising the debt ceiling does not authorize new government spending; instead, lifting the ceiling simply enables the release of payments for previously authorized spending obligations. If the debt ceiling isn’t raised, then payments to entitlement programs such as Social Security and Medicare may not be made and interest payments on U.S. Treasury bonds could cease as well.

While the incentives for avoiding a default seem obvious, it can become a political tool for opposition parties to extract concessions from the party in power, leading to partisan wrangling of the type that we’re witnessing now. As of this writing, we view an eventual debt ceiling increase as the most likely resolution of the current situation; indeed, since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. However, we believe that we must consider alternative outcomes, as the economy can be damaged simply through an erosion of consumer confidence as debt ceiling negotiations drag on. Any temporary default could affect the country’s creditworthiness, the intended recipients of the impacted payments for entitlement programs, and Treasury bond investors. While we consider the scenario of a longer-term or permanent default highly unlikely for now, such an outcome could create systematic problems.

Takeaways for investors from 2011’s debt ceiling crisis

We believe the lessons that we’ve learned from analyzing the U.S. government debt ceiling battle of 2011 are relevant for investors and their portfolios as today’s predicament continues to play out. Both conflicts came in a time of divided government, with Republicans securing a new majority in the House of Representatives earlier in the year while a Democrat held the White House. In both cases, House Republicans used the need to raise the debt ceiling as leverage for deficit reduction and balancing the federal budget deficit. In 2011, the resolution of the conflict ultimately led to passage of the Budget Control Act of 2011, which raised the debt limit in two installments with the intent to cap discretionary spending.

To better understand the 2011 debt ceiling crisis, it’s important to review the timeline leading up to that year’s August deadline to lift the debt ceiling. In April, in a first-ever action of its type involving U.S. sovereign debt, Standard & Poor’s downgraded its outlook from stable to negative for the top-tier investment-grade AAA rating that the U.S.-based credit rating agency had assigned. In doing so, the agency warned that a downgrade to less than an AAA rating was possible if Congress and President Obama failed to enact a credible deficit-reduction plan. Three months later, on July 31—some 72 hours before the nation’s borrowing capacity was projected to be exhausted, absent an increase in the debt ceiling —Congress and the president announced an agreement to reduce the deficit and therefore lift the debt ceiling. On August 2, the measure was signed into law after clearing Congress. Yet in the aftermath of this agreement, Standard & Poor’s on August 5 followed through on its earlier issuance of a negative outlook by downgrading U.S. sovereign debt by a notch to AA+.

That spring and summer, the stock market was slow to respond to the mounting debt ceiling risks at a time in which Europe was also struggling with its own sovereign debt crisis. Using the S&P 500 Index as a proxy, the index reached its 2011 peak in late April, then pulled back before rallying again in late June and early July.¹ The sharp decline didn’t begin until July 27—three trading days before the weekend announcement that Congress and President Obama had reached a deficit-cutting deal. By August 8, the first trading day following Standard & Poor’s downgrade, the index had dropped nearly 16% from its July 26 closing level. Over that span, the index tumbled for eight of nine trading days before hitting a trough. (The S&P 500 Index eventually fell another 2%, sinking to a further trough reached on October 3, but the damage had already been done.)

Source: FactSet, 2023. The S&P 500 Index tracks the performance of the 500 largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Unsurprisingly, the worst-performing areas of the S&P 500 Index were cyclical sectors, which are typically highly sensitive to changes in the economic outlook, such as financials, materials, and industrials; the sectors that outperformed were historically defensive ones, such as utilities, consumer staples, and healthcare.¹ The index went on to stage a rally after the October low, and 2011 ended basically flat for the year. The market turbulence of 2011 wasn’t contained to the United States, as the MSCI World Index and the MSCI EAFE Index both generated similar declines over the course of the year, although they didn’t experience the subsequent year-end rally witnessed in the United States.¹

Implications for today  

As we approach the current debt ceiling deadline, we expect that the U.S. Department of the Treasury will take extraordinary measures to fill the gap and draw down its cash holdings, typically maintained at around $500 billion. The other issue we therefore need to consider is what actions the Treasury may take after any agreement to lift the debt ceiling—an outcome that we believe is the most likely scenario as of this writing. How quickly might Treasury Secretary Yellen seek to refill her agency’s depleted cash holdings? Such a process could amount to a draining of liquidity from the broader financial system, which could have some degree of an impact on liquidity across markets. 

Until this issue is resolved, we don’t view it as unreasonable to be concerned about the potential for a government shutdown, a U.S. default, and a repeat of the debt ceiling-induced volatility experienced in 2011. In an environment of high uncertainty such as this one, we maintain a positive view of companies with strong quality characteristics—strengths that we feel enable select firms to distinguish themselves from their peers. In essence, these companies offer sustainable free cash flow growth and provide the potential for downside protection when the external environment deteriorates—attributes that we believe could become increasingly important in this environment.

1 FactSet, 2023. The S&P 500 Index tracks the performance of the 500 largest publicly traded companies in the United States. The MSCI World Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies. The MSCI Europe, Australasia, and Far East (EAFE) Index tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. It is not possible to invest directly in an index. Past performance does not guarantee future results.