Last Wednesday we had our quarterly client webinar. The focus on the first part was the Federal Debt Ceiling issue. Because so many of you have expressed concern, here is a summary of that part of the call.
On May 16, the Treasury reached this statutory limit. The Treasury receives tax revenue every month and has some money in its checking account and was therefore able to continue spending without increasing the overall stock of debt outstanding. However, the Treasury expects to be out of money by about August 2 and unable to meet all of its commitments without additional borrowing.
It is difficult to know the nature of the negotiations behind the scenes, but the rhetoric is clearly political. In this context, we see three most likely outcomes: a last minute deal; a short-term increase is enacted as negotiations continue; or borrowing authority lapsing on August 2, with an agreement reached a few days later. Given the nature of the debate, there is no political benefit to acting until the last minute, so we are unlikely to get clarity in the last minute.
First, if the August 2 deadline is missed, it is difficult to see the debate dragging on to August 15, when interest payments are made. Congress is scheduled to go on recess after August 5; in the past, seemingly intractable political disputes have often been resolved around the start of congressional recesses.
Second, even without an increase in the debt limit, tax revenues provide plenty of funds to cover interest payments (currently only 6% of the federal budget, compared to over 20% each for defense, health programs and Social Security) and the Treasury is likely to prioritize debt service payments. The legal issues are not settled, but it appears that debt service could be prioritized over other spending. Prioritization did occur previously, following expiration of a temporary increase in the debt limit on July 1, 1957. As the federal government began to run a budget deficit, the Treasury was forced to delay payments to federal contractors in order to avoid breaching the limit. More recently, as the debt limit was approached in early 1996, the Treasury indicated that failure to raise the debt limit would result in failure to make Social Security payments, though Congress provided relief before any delay occurred. Since prioritization would probably start on August 3, the Treasury’s ability to prioritize would be well established before the August 15 interest payments.
The third reason that default is so unlikely relates to the extreme consequences if it did occur: the end of the financial world as we know it. The turmoil in the wake of the Lehman collapse would pale in comparison to the chaos that would result from a default on Treasury bonds. In the first few days, money market funds would “break the buck” and capital would flow out of government bond markets around the world into… what? Banks’ balance sheets would be harmed anew, and the public’s confidence in governments’ ability to backstop deposits could be seriously questioned, potentially causing a run on the banks worldwide. When Russia missed an interest payment on its debt in 1998, the most recent example of a major sovereign debt default, global equity markets were instantly pummeled by over 20%... and this due to a default by a third-rate economic power. A default by the world’s most credit-worthy borrower is a scenario which is truly unthinkable. And congressional leaders, for all of their posturing and bravado, know it, making it very unlikely that a default will actually come to pass.
Even absent a default, a significant problem would be created if the rating agencies downgrade Treasury securities in the coming weeks, even to the still very respectable AA (the same rating held by Japan and New Zealand, for example). Many types of investors (including some money market funds) are limited to holding AAA-rated bonds and would be forced to sell, raising interest rates across the economy and putting further pressure on economic growth, possibly tipping the US (and even global) economy back into recession. At some point prior to August 2, markets may become concerned about this scenario. The exact market dynamic would depend on the economic backdrop over the next few weeks (e.g., negotiations over the Greece bailout), but general market volatility would likely increase substantially.
Two things about the stock market: 1. It is a good long term rational predictor of the future. 2. Short term it is insane, it over-reacts on both the upside and the downside. Expect the stock market to overreact—but don’t overreact if it does. One possibility is that the markets will fall. Even if prices drop, nothing fundamental will have changed about our economy. The lower prices may actually offer investors some excellent opportunities to buy. For most investors, our advice would be to sit tight and do nothing. If you are properly diversified with a portfolio of different asset classes (which all of our clients are), some of those classes are likely to increase even if others fall.
If the markets drop its bargain time. The sale won’t last long. If the debt ceiling isn’t increased by the deadline, and voters start seeing delays in payments such as Social Security, members of Congress will be hearing from the public in very strong terms.
We (Debbie and I) are literally talking about this daily. Discussing the risks AND opportunities. Should we make any changes and if so, what? If we reduce or sell an asset class, where do we put the money? What would be a trigger to make a change? So far, we don’t see strong enough reasons to make changes.
What should you do? Sleep well. Overall, there’s not much point in losing sleep worrying about the “Debt Ceiling Crisis.” Markets and interest rates may be affected in the short term, but they will most likely rebound. Anyone who misses a government paycheck will be reimbursed as soon as the ceiling is lifted.
Even if the August 2 deadline passes with no action, it’s doubtful that our politicians will find it tolerable to delay increasing the debt ceiling for very long. Perhaps our best course of action is to hope all the media attention helps encourage America’s leaders and the American people to make real progress toward overcoming our addiction to borrowing
Over time, we expect stock and bond markets to react favorably to the increased focus on fiscal austerity at all levels of government throughout the world. The political theater that’s playing out in Washington is driven by the same forces that we’ve seen recently in many US states and, more dramatically, in Greece. Economists have been saying for years that Western economies were spending above their means and that dramatic changes were necessary to avoid eventual catastrophe; happily, it appears that real momentum has swung behind fiscal responsibility. With a few exceptions among the world’s more marginal economies (like Iceland and Greece, which may in fact buckle under the weight of their debt) it appears that we’re addressing our fiscal issues in time to avoid an even more painful reckoning in the future. The turmoil we see about us now are the difficult, but necessary, convulsions that society apparently must go through to chart a new, healthier path forward.