Should Investors Alter Portfolios in Response to Debt Ceiling Risks?
No. We think most investors should not alter portfolios based solely on debt ceiling risks. Instead, they should remain focused on the long term and rely on the diversification in their existing portfolios. But given the potential for additional stress in funding markets, investors should ensure they have ample liquidity to meet upcoming capital calls and spending needs.
The US debt limit is hardly a novel issue, rearing its ugly head every several years. In fact, Congress has effectively raised the debt ceiling nearly 80 times since 1960, avoiding default in every instance. The policy, originally instituted in 1917, caps total outstanding US gross federal debt, which can only be adjusted through Congressional legislation. The current debt limit of $31.4 trillion was hit on January 19, and since then the Treasury has resorted to emergency funding measures to pay its bills. Due to the difficulty of forecasting tax receipts and spending needs, there are a wide range of estimates as to when the government will run out of cash, often referred to as the “X-date” by the press. However, earlier this week, Treasury Secretary Janet Yellen warned the United States could default on existing obligations as early as June 1, as tax receipts in April were weaker than expected. The key concern is that, given the tightening deadline, a divided Congress and political brinksmanship will push the Treasury to default on its debt obligations. Politics are unpredictable, but US policymakers have always negotiated a deal in time to avoid default.
The current stand-off rhymes with the 2011 episode, where an eleventh-hour deal was tied to spending cuts. And late last month, House Republicans passed a bill doing just that. However, that bill was widely viewed as a non-starter from Democrats, given spending cuts to key Biden administration initiatives, such as the Inflation Reduction Act. Indeed, Moody’s estimates the current House proposal would result in weaker economic growth and nearly 800,000 fewer jobs by year-end 2024. This is compared to a “clean” solution, where the debt ceiling is lifted without meaningful changes to fiscal policy. Still, the probability of a compromised deal in which House Republicans agree to raise the debt ceiling in exchange for some spending cuts has increased in recent months.
While a negotiated outcome avoids default, financial market volatility would likely increase as the X-date approaches, raising the risk of a financial accident. Further, the threat of a ratings downgrade raises the risk of disruption in funding and collateral markets. Indeed, Standard & Poor’s downgraded US debt in 2011 although a deal was reached. For US equity markets, volatility may rise significantly. Recently, 30-day realized equity volatility was just below 12%, which is slightly less than its 20-year median, but it spiked to more than 40% in 2011. Longer-dated Treasury yields would likely fall from three perspectives: flight-to-quality demand, potential monetary policy support from the Federal Reserve, and a diminished near-term growth outlook, particularly if a deal is tied to spending cuts.
However, history suggests that financial markets tend to rebound quickly following US debt ceiling crises. In fact, in every major debt ceiling stand-off over the past ten years, a broad US equity index price level was above pre-deal levels within 90 days after an agreement was struck. This also holds true for a 60/40 portfolio of US equities and investment-grade bonds.
No deal and a US debt default remain a tail risk, which would be difficult and expensive to fully hedge. Despite the posturing to date, a default is a highly unpalatable political outcome. Such a default would almost certainly trigger downgrades of US sovereign debt, increase the cost of borrowing, tighten credit conditions, pressure the US dollar’s reserve currency status, and freeze short-term funding markets. The market fallout would likely apply significant pressure on lawmakers to identify a swift resolution. There are several avenues that a near-term default could be avoided, including prioritization of interest and principal payments over other obligations. But these measures would likely face legal challenges, do little to avoid a ratings downgrade, and still result in substantial, if yet unknown, negative economic growth impacts. Reflecting this outcome, spreads on credit default swaps for short-dated Treasury securities have widened to record highs, suggesting the market is pricing in a non-zero, but still very small, probability of default.
This episode adds to recent economic headwinds, including banking sector stress and tight monetary policy, which reinforces our view that recessions are forthcoming in the United States and Europe. Based on this view, we continue to suggest that investors keep broad equity allocations in line with policy target levels.
Stuart Brown
Investment Director, Capital Markets Research
TJ Scavone
Investment Director, Capital Markets Research