Debt Ceiling is a Worry, but a small one
The same melodrama is playing out yet again. Absent congressional action, the US Treasury will default on its obligations later this year. Other than inflation and interest rates, the most important issue that US equity markets face in 2023 is the debt ceiling debacle. A default would hit confidence and financial conditions, likely resulting in a sharp recession. Unlike federal government shutdowns, which occur frequently, a default would do long-lasting harm.
That, of course, is the worst-case scenario and one that I place less than a 5% chance of occurring. More likely, the worst-case scenario would be the brinkmanship that occurred in 2011 when S&P downgraded our debt.
Markets don’t seem to care about the debt ceiling right now. As of Friday, Feb 24, 2023, the S&P 500 is up 3.7% and the Nasdaq is up +9%. Bonds are also rallying though interest rates have risen a bit as of late offsetting some of that strong start.
I think part of the reason markets don’t seem to care is we’ve all been through this before and know that it’s mostly political theater. The debt ceiling debate makes politicians feel important. They use it as a negotiating ploy to pass or block other legislation. It’s leverage.
Both parties’ bases would probably view it as a failure if their leaders found agreement early on, and so this debate looks likely to drag on quite close to the X date. Granted, there are also those in both parties who would view any compromise as worse than a default—with the hope the other party takes more of the blame for the fallout of a default. However, for the most part, pragmatism wins the vast majority of the time and especially when it is something truly important.
Could we see some crazy politician takes things too far at some point and force a default? It wouldn’t surprise me but that seems like a short-term problem that would be remedied quickly once they see the problems it would cause.
The fight over the debt ceiling is often described as a game of chicken where congressional Republicans and the administration each hold until the last-minute waiting for the other side to blink before a default is reached.
From the Wall Street Journal:
Mr. Biden is adopting much the same stance then-President Barack Obama did in 2011, when the U.S. came close to, but didn’t pass, the X-date. The Biden administration says raising the debt ceiling simply allows Treasury to pay obligations Congress has already agreed to and should be done without conditions. Biden officials say they cannot “prioritize” debt payments—use incoming revenue to pay interest on the national debt, thereby avoiding a debt default, while defaulting on other obligations, from Social Security and Medicare payments to military salaries and supplies. But Mr. Biden has an uphill climb convincing Republicans and markets he will not negotiate or prioritize. Mr. Obama in 2011 said he wouldn’t negotiate, but he did. More precisely, then-Vice President Biden did, leading several months of talks that formed the core of the eventual deal.
The Numbers for those that like the Data!
In 2011, S&P downgraded US debt. It felt like a massive deal at the time. I can even remember CNBC commentators calling it the next 2008 event. From the BBC story[1] released the next day after the downgrade:
The agency said the deficit reduction plan passed by the US Congress on Tuesday did not go far enough. Correspondents say the downgrade could erode investors’ confidence in the world’s largest economy. It is already struggling with huge debts, unemployment of 9.1% and fears of a possible double-dip recession. The downgrade is a major embarrassment for the administration of President Barack Obama and could raise the cost of US government borrowing. This in turn could trickle down to higher interest rates for local governments and individuals.
Sounds really bad, right?
Well, the markets completely shrugged it off. The Monday after the downgrade was announced the S&P 500 crashed more than 6%. That’s a big down day. But the next day it was up 5%. The day after that it was down more than 4% and the day after that it bounced more than 5%.[2]
So we had down 6%, up 5%, down 4% and up 5% back-to-back-to-back-to-back. It was a volatile time for sure.
However, a year later, the S&P was up almost 20%. Interest rates actually fell. In fact, a year later, the 10-year treasury rate was 1% lower than it was before the downgrade.[3]
What the 2023 debt ceiling dram could do the economy and the stock market is anyone’s guess, but there is probably less cause for alarm than most think. That’s because the market does a good job of pricing in risk events that have a date associated with them. Risk usually happens when investors get blindsided by news they did not expect or news that is worse than expected.
The table below shows all of the debt ceiling games that congress has played over the last few decades and the performance of the S&P during that time frame. The only down time period was 2011. The last shutdown in 2018-2019 the S&P 500 was up over +10.4%. Even during the ‘crisis’ period was up +2.7%.[4]
[5]
The government has until June to figure its junk out. Given its congress, they will wait until the last possible second to act. That’s a given. Especially since they believe it adds to their re-election efforts.
I respect risk. I don’t mean to trivialize this. But with all that investors have to worry about right now, the debt ceiling is very far down my list.
Noble Wealth continues to focus on risk management and dynamic asset allocation. That means we attempt to minimize your risk to achieve the return hurdle we have assumed in your financial plans. Most financial advisors, surprisingly, do the opposite, and take the most risk your financial risk tolerance scorecard allows even if you don’t need it to reach your objective.
Our portfolios are heavily skewed away from equities now because, thanks to high inflation and the Federal Reserve, we have juicy yields in high-quality bonds. Many of you have seen these transactions in your accounts.
We have been purchasing BBB or better bonds yielding 6%+ to maturity. We think by locking in these yields for as long as possible makes sense because they will only be around for so long as the Fed is fighting the inflation battle. Once inflation is defeated, rates will come back down and the opportunity to buy these bonds will be gone.
As always, we value the trust you place in us. If you have any questions or would like to schedule a meeting – either in person at our new office or via Zoom- please do not hesitate to reach out to us.
Sincerely,
Mark J Asaro, CFA
Noble Wealth Management
[1] https://www.bbc.com/news/world-us-canada-14428930
[2] https://finance.yahoo.com/quote/SPY/history?p=SPY
[3] https://www.bloomberg.com/quote/SPY:US?leadSource=uverify%20wall
[4] https://www.investopedia.com/news/how-shutdowns-dont-affect-market/
[5] https://www.forbes.com/sites/bill_stone/2021/09/26/the-market-impact-of-a-possible-government-shutdown-and-reaching-the-debt-ceiling/