Quick Market Update
Debt Ceiling Blues—A Refrain
October 3, 2013
Paul J. Mangus, CFA®
Managing Director, Equity Research & Strategy
Darrell Cronk, CFA®
Regional Chief Investment Officer
In this Quick Market Update:
Debt ceiling déjà vu?
On October 17 the U.S. government is anticipated to run out of funding to pay all its bills without Congress passing legislation to increase the debt ceiling.
Political disagreements are creating a great deal of market uncertainty over whether the legislation will pass.
Investors should prepare for a period of heightened market volatility as we head towards this deadline.
On May 19, 2013, both the U.S. Senate and House of Representatives agreed to raise the U.S. debt ceiling to approximately $16.7 trillion dollars. U.S. Treasury Secretary Jacob Lew recently warned Congressional leadership that the federal government would run out of funding by October 17, 2013, if the U.S. debt ceiling were not raised again. The rhetoric escalated on Wednesday, when President Obama asserted that Wall Street should be concerned about an impasse over the debt ceiling debate.
Debt ceiling increases are nothing new for the U.S. government; as the chart below illustrates there have been 79 legislative debt ceiling increases since 1940. A political focus on government deficit reduction, however, has made negotiations over the debt ceiling more contentious in recent years. In this Quick Market Update we explain the risks to the economy and markets if a debt ceiling increase is not approved, and what measures investors should consider taking to protect their portfolios from a period of potentially heightened market volatility.1
Debt Ceiling Increases since 1940
What happens if Congress doesn’t act to raise the debt ceiling?
One of the primary concerns for many investors, and specifically foreign investors in U.S. government bonds, is that without a resolution to raise the debt ceiling the U.S. government could default on its debt repayment obligations. If this should happen, the faith that many investors place in U.S. government bonds as a relatively “risk-free” investment likely will be shaken. As a result, interest rates may rise to compensate investors for the additional risk associated with holding this type of security.
But the U.S. government does have other viable options to deal with the situation. In essence, outside of an outright default on its debt obligations, the government could decide to furlough nonessential employees, and cut or defer expenditures, such as Social Security and Medicare payments, military salaries, tax refunds, and payments to vendors for goods and services. Yet, cutting or deferring expenditures also could have a decidedly negative impact on the economy. Over a longer time period, the government could potentially seek to raise funds through privatization of government-owned enterprises.
During the last contentious debt ceiling debate in August 2011, the government furloughed some employees but negotiated a spending reduction plan (sequestration). The ironic thing is that, from a political perspective, very few things have changed since that last major debate, despite “not spending” on previously approved plans. From a market perspective, however, there are some key differences. The period leading up to the August 2011 negotiated debt ceiling settlement was an emotionally charged time for nearly all markets with long-range implications. In addition to the debt ceiling debate in the U.S., global markets were dealing with several other financial issues including the European debt crisis, the Standard and Poor’s downgrade of the U.S. sovereign debt credit rating, Quantitative Easing Two (QE2) and Operation Twist.2 Each of these contributed to the widespread market volatility during the summer of 2011.
In contrast, we believe that the market risks contingent upon the budget and debt ceiling negotiations are lower today than two years ago for several reasons:
The U.S. budget deficit-to-GDP ratio has declined from 7.2 percent at the beginning of 2013 to roughly 4.2 percent today, reducing the risk of additional sovereign debt downgrades.
The Congressional Budget Office (CBO) estimates that the U.S. budget deficit has been cut in half since the beginning of the year, reducing fiscal demands and pressures to cut spending from both parties. Recent 2013 increases in payroll taxes, dividends paid to the U.S. Treasury in excess of $95 billion so far this year from Fannie Mae and Freddie Mac from improvements in the housing market, and stronger individual and corporate tax revenues from an improving economy have all been strong contributing factors to this significant reduction in the budget deficit estimates.
Accommodative monetary policies from the Federal Reserve should help relieve fiscal pressures.
Nonetheless, while even contentious debate is a natural characteristic of a democratic system of government, the one element that triggers most market dislocations is uncertainty. What we do know is that, with each side of the debate adhering to their convictions with little in the way of harmony, market uncertainty is heightened. The likelihood of an amicable settlement of the looming debt ceiling deadline appears highly questionable. This is not to say that the winds of politics might not shift in the next two weeks, but the markets are becoming increasingly skeptical over the recent level of discord in Congress. This suggests that, at least in the short-term, we can expect more episodic swings of market volatility than usual.
What should investors do given this uncertainty?
While it’s difficult to speculate on the outcome of the debate, investors can take measures to help protect their portfolios from the market uncertainty and intermittent volatility. We continue to favor domestic equities for the longer term, but recognize that this asset class has performed considerably well so far this year. If a portfolio has risen significantly above your long-term strategic allocation, we suggest taking profits to realign the portfolio or, at the least, hedging the equity exposure. On the other hand, if a portfolio is underinvested in any of our recommended four asset groups (stocks, bonds, real assets, and complementary strategies), investors may want to consider adding to any underweighted segments during periods of potential weakness in the markets. We expect the recent respite in market volatility is likely to be interrupted as negotiations in Congress over the debt ceiling become even more heated. To help protect a portfolio from an extended period of market volatility, it is important to have sufficient cash or cash equivalents to avoid drawing on your investment portfolio to meet short-term obligations. If you have questions or would like to review your current holdings, we encourage you to contact your investment professional.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
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1 CNBC, 9/10/2/13
2 “Operation Twist” describes a monetary process in which the Fed buys and sells short-term and long-term bonds depending on their objective. In September 2011, the Fed performed Operation Twist in an attempt to lower long-term interest rates.