The U.S. Government hit its legal debt limit of $31.4 trillion in debt on January 19th, 2023, so what happens next?
Hi everyone, Jay Pluimer here with Flourish Insights. As the director of investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. If you’ve been enjoying the show, be sure to subscribe on Apple, Spotify, Google, or wherever you get your podcasts, so you’ll never miss an episode.
Today, we are discussing The Debt Ceiling Question.
An interesting comment about recording this episode in late February is that over 95% of the articles I looked at about the debt ceiling were dated in mid- to late-January. That’s odd because we are a month closer to running out of money but conversations about the debt ceiling are no longer grabbing headlines or being featured in doom-and-gloom articles. Just a guess, but debt ceiling articles will become all rage again and grabbing attention at some point in June because that’s when the debt ceiling will be approaching a final expiration date.
The US Government hit its legal debt limit of $31.4 trillion in debt on January 19th, 2023. By definition, the debt ceiling sets the limit that the US Government can borrow to keep the country running. The US has used debt ceilings since 1917 to cap government spending, although its been a very flexible cap that has been raised or suspended 102 times over the past 104 years. The US can continue to spend and borrow money for a few months due to “extraordinary measures” by the Treasury Department and the Federal Reserve, but those can’t keep the government afloat for more than about 6 months.
Congress is in charge of the debt ceiling and is responsible for resetting the debt limit as needed. The last extension took place with minimal fanfare back in 2021 when Covid relief spending still had bipartisan support. In contrast, partisanship is all the rage in Washington DC these days as both sides of the political aisle are using the debt ceiling topic as a beach ball to whack back and forth in the Halls of Congress. The odds are in favor of a deal happening at some point over the next few months because there has never been a time when the US failed to increase the debt ceiling or defaulted on debt payments.
The closest call to a default took place in 2011 when negotiations concluded just 2 days before the US was going to run out of money. The close call resulted in the first and only downgrade for the US Credit Rating from AAA to AA+, plus the US Dollar sold off and the stock market dropped by over 16%. An uncomfortable similarity between now and 2011 is that we had the exact same political configuration then as we do today with a Democratic President and Senate paired with a Republican majority in the House of Representatives. Many analysts and commentators have expressed surprise that the US Stock Market is up over 8% through the first 7 weeks of the year with the debt ceiling crisis looming over the markets.
Without getting into the weeds of political discourse in Washington DC, both parties have legitimate arguments about how the US Government should or shouldn’t spend money in the future. Although there don’t seem to be any adults in the room to help politicians put their egos on the back burner and negotiate in good faith at the moment, there is hope that fear will eventually provide the motivation necessary for a solution to take place. And there is good reason for politicians from whichever party looks most responsible for failing to negotiate in good faith to be fearful because Republicans took the brunt of the blame for the debt ceiling crisis in 2011 and then performed poorly at the polls during the 2012 election.
From my perspective, the debt ceiling crisis will most likely get lumped into conversations about persistently high levels of inflation that will continue to be a problem through the first half of 2023. Although these considerations are independent of each other, it’s hard to argue with the coincidence when two worrisome things are happening at the same time. However, if the stock and bond markets start to dip in April and May due to these concerns that will put additional pressure on Congress to make a deal. The most likely outcome is increased market volatility with the potential to give up most or all of the gains from the first couple of months of 2023 until a deal happens. At that point we expect the Fed to be closer to the end of their interest rate increases which should provide a dual tailwind for the markets during the second half of the year.
What is the worst-case scenario? There are scenarios where hardliners from either or both political parties refuse to negotiate and commit to turning the global markets upside down. That could put not only the credit rating of US debt at risk but it would also likely result in a significant downfall for the US Dollar, creating a powerful double whammy that would be hard to recover from. The global economy does not want this scenario to take place because there isn’t another great option for a default currency or a safe lender that issues as much debt as the US does on an annual basis. I don’t want to go too far down this line of thought because the chances of a default happening are low… but they aren’t zero.
What should investors do to prepare for something that may or may not create significant market turmoil? Historical evidence consistently demonstrates that the best option is to stay fully invested, maintain a diversified portfolio, add money if possible during a downturn, and make sure you have an emergency reserve to support at least 6 months of spending if a worst-case scenario takes place. Our Team at Flourish will provide as much education as possible throughout the political negotiating process, staying optimistic for a timely resolution while also being prepared for a default. In addition, I recommend that you avoid getting too invested in watching headlines or articles while the politicians in Washington DC play beach volleyball with the debt ceiling topic. None of us can influence this conversation until the next time we vote, so it won’t help anybody to get too wrapped up in the debt ceiling conversation.
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