What is the debt ceiling?
Every year, Congress must pass a budget that lays out the entirety of Federal government spending for the fiscal year. In years when the government’s budget exceeds its revenue from things like taxes, it is forced to borrow money in order to make payments on its already existing debt obligations. The US government borrows money mainly by issuing treasury bonds to investors, both foreign and domestic. More on this later…
The debt ceiling was a concept first introduced in 1917. It is a self-imposed cap on the amount of new debt the government can take on in order to avoid defaulting on its existing debt payments. As the Treasury begins to run out of money to make its debt payments, Congress is forced to either raise the debt ceiling to allow for more borrowing, or stop making its debt payments, resulting in default. A US default on its debt has never happened.
Why does this matter?
“Unprecedented” is a term that gets thrown around a lot these days, especially in the worlds of both politics and investing. But a US credit default would be truly unprecedented and the consequences would have ripple effects around the world. If Congress is unable to put politics aside and raise the debt ceiling in order to pay for the very spending its own body has already approved time and again, not only would US bond investors suffer the immediate consequences, but so would everyday Americans.
There are nearly 15 million Americans that would stop receiving social security payments. Members of the military would stop getting paid. Benefits programs for Veterans would stop. Nearly all Federal employees could stop receiving paychecks as well. The list goes on and on. But all of this has broader implications for the economy, like an obvious hit to economic growth, and possibly even an economic recession.
What happens next?
As is often the case in Washington, the goal posts are constantly moving and negotiations are likely to take this particular debate into the 11th hour. However, it’s worth noting that we have been here many times before. In fact, since 1960 alone, Congress has voted 80 times to increase or suspend the debt ceiling. Things haven’t always been as divisive as they are today, but the most likely scenario is that cooler heads will indeed prevail when all is said and done. No politician wants the blame for a self-inflicted crisis.
That said, anything is possible. And even if we do assume the most likely outcome will occur, we have to prepare ourselves for some wild weeks of uncertainty ahead. And yes, we even need to consider the unlikely chance of the worst outcome—a US default.
What should you do with your retirement accounts?
It’s a safe bet that regardless of the outcome, the uncertainty alone is bound to rile up the stock market, reintroducing volatility that we haven’t really seen with stocks in the last year or so. In our view, this isn’t necessarily a bad thing. In fact, with a long-term perspective in mind, it could be a much needed opportunity for those with a disciplined approach and a personalized strategy in place.
For some historical context, in 2011, when it appeared we were as close as ever before to Congress failing to raise the debt ceiling and the US defaulting on its debt, US stocks declined broadly by roughly 17%. In that particular instance, even though the debt ceiling was raised at the last minute, the drama of it all revealed to the world that the US might not be the safe haven it once was for bond investors. This resulted in a downgrade of the US credit rating and a spike in interest rates, which is something the market likely would not take well in today’s environment.
At that time, there were endless apocalyptic predictions similar to what you might be hearing or reading about today, but as the dust settled, investors around the world came to a key realization: While the US may be a higher default risk today than it once was, due mainly to political polarization, where in the world today is that not the case?
Note: Since the debt ceiling induced correction of 2011, the S&P 500 has risen roughly 375%. Patience pays.
While another downgrade is possible even with an eventual agreement to raise the debt ceiling, either outcome could cause a short-term correction in stocks. But there are an endless number of totally unrelated possibilities that could also cause a correction in stocks on any given day.
We see little reason to believe that following any potential panic, investors will not eventually realize that from a global perspective, default risk to the US is relative. The US remains the most important economic engine in the world today and while our politics have become messier and messier in recent years, it’s hard to find another free society where that isn’t the case.
The bottom line
This may very well become the catalyst for a correction that many believe we’re overdue for anyway. It also might not. Predicting short-term outcomes, or attempting to, is a recipe for ruin when it comes to your long-term investments, like those in your retirement accounts. While it’s important to be aware of what’s happening in Washington in order to stay informed as a citizen, it’s best to take off your investor hat before stepping onto a ride like this, especially when we’re talking about an investing goal that is years or decades away for many, if not most of you.
If anything, it’s important to remember that these politically driven market events aren’t likely going away in your lifetime, and you shouldn’t change your long-term strategy every single year based on short-term speculation, or worse yet – your own personal political beliefs. Our advice is to stay informed, but stay the course. Know that our team is tuned into all of this and happy to discuss your concerns if you have them. And if you’re losing sleep over all this, maybe you’re taking too much risk and it could be time to revisit your risk tolerance. Lean on us in times like these. That’s why we’re here, after all!
The information is provided for discussion purposes only and should not be considered as advice for your investments. Past performance is no guarantee of future results. Please consult an investment advisor before you invest.
Published on October 6, 2021