The government shutdown has gotten most of the press coverage so far, but there is a related and bigger issue pending in the next couple of weeks: the debt ceiling. Although the federal government has partially shut down, it continues to spend money on many items. Normal government financing requires regular additional borrowing, as we typically spend more than we take in.
The U.S. government operates subject to a legal limit—the debt ceiling—on how much overall debt can be issued. In order to increase the limit, Congress must authorize the raise. Until 2011, this was regularly done, albeit with a certain amount of protest and commentary. In 2011, for the first time, Congress refused to authorize raising the limit until after the Treasury had hit it, causing fear that the government would actually run out of cash. Ultimately, of course, Congress did approve an increase, but not until the stock market and economic confidence had taken a hit.
Back to today: Since hitting the debt ceiling in May, the government has been using the “usual extraordinary measures”—such as giving IOUs to government-employee retirement funds—to find money to pay the bills. These measures are expected to run out in mid-October, leaving insufficient cash to fulfill all of the government’s obligations and forcing the Treasury to choose who gets paid and who doesn’t.
There are two critical points to keep in mind here. First, all obligations will ultimately be paid. This is a political crisis, not an economic or fiscal one, and the real risk associated with U.S. government obligations remains the same as always—essentially zero. There’s a reason U.S. Treasury interest rates are treated as the “risk-free rate.”
Second, even though obligations will ultimately be paid, the short-term uncertainty created by the debt ceiling debate has made that risk-free rate materially less risk-free than before—at least in the eyes of markets. Short-term interest rates on Treasury bills have spiked, although they remain at low absolute levels. Default swaps on U.S. debt have increased materially in price. No one expects the U.S. to default, but investors aren’t quite as confident as they have been.
We can use this context to determine how to manage our portfolios. On a long-term basis, the effects should be limited to slightly higher longer-term interest rates and slower growth. From a long-term perspective, this will be a negative, but no more so than other factors, requiring more adjustment of our expectations than of our portfolios.
On a shorter-term basis, the effects could be more marked. In 2011, the last time we came close to hitting the debt ceiling, the S&P 500 dropped about 16 percent. We have seen some downward movements in the market that suggest worry is starting to affect trading, and the potential for a market correction as we move closer to the debt ceiling cannot be ignored. For most investors, with appropriate allocations, any correction could and should be ridden out—just as we did in 2011. For anyone really worried about the impact, it may be appropriate to reexamine your portfolio as a whole and reduce your overall risk. At the same time, it’s possible that any correction could actually be a buying opportunity, as many commentators are currently saying.
The debt ceiling debate is an example of an event that could have significant short-term effects, with relatively little effect in the long term. With that in mind, we recommend riding out any short-term turbulence and sticking to a well-thought-out asset allocation model. This too will pass.