2011 Debt Ceiling Debate

Key Points

• There is a material possibility that Congress will be unable to reach a deal to raise the debt ceiling by August 2nd
• Regardless of whether or not such a deal is achieved, an actual default by the U.S. Government is highly unlikely
• The market impacts of failure to reach an agreement by August 2nd are highly unpredictable and quite likely to be short-term in nature
• Clients should be prepared for some short-term volatility as a result
• We have not had a single conversation lately that did not include something about the debt ceiling debate in Washington and its potential impact on capital markets and our investment portfolios

Background

The debt ceiling, also known as the debt limit, is the maximum amount of gross debt that the U.S. Government is allowed to borrow. It was initially created in 1917 as a result of the government’s borrowing to fund World War I and has been raised 74 times since 1962. It has been raised repeatedly by administrations of both political parties, most recently in February 2010.

The current debt limit is $14.3 trillion, which was actually surpassed on May 16, 2011. The Treasury
Department has employed some bookkeeping maneuvers to hold off actually defaulting until August 2. Failure to raise the debt limit would mean that the government could not borrow additional funds for any reason.

While limiting our government debt sounds intuitively appealing, it does have some very important consequences, which we discussed in our recent Quarterly Newsletter (available on our website). Since our government borrows about 40 cents for every dollar it spends, it is clear that failure to raise the debt ceiling could result in substantial and immediate cuts in government services.

The Situation

With this background in mind, the current debate has focused largely on how much to raise the debt limit and how much in the way of budget cuts or tax increases should be attached to raising the limit. Proposals have varied widely, but for our purposes, there are at this point three potential outcomes from the debate. These are:

1. No deal is reached, resulting in the government defaulting on Treasury bond obligations.

2. No deal is reached, but the government continues to pay Treasury bond holders while prioritizing payments for other things.

3. A deal is reached (more or less at the eleventh hour).

Below is a discussion of each of these possible paths:

Path 1: No deal and default

We feel this is the least likely outcome, as it is the one outcome which would cause the most long-term damage to the economy. Under this scenario, the U.S. Government would not pay some or all interest and principal payments to holders of Treasury bonds, resulting in a technical default, downgrade of our credit rating and a whole host of other follow-on effects.

If this were to happen, interest rates on all loans to American businesses and consumers would likely rise, though the amount of the change is completely unpredictable. In addition, since Treasury bonds make up a large portion of most banks’ capital, it’s likely that most bank lending could be impaired until a resolution is reached. Furthermore, since Treasury obligations are the underlying security for most transactions in the cash markets, money market mutual funds would have a very difficult time preserving their $1.00 net asset value. Finally, it’s probable that the stock market would have a severe negative reaction as well.

In short, the magnitude of the impact of a default on Treasury bonds is highly unpredictable and would touch nearly every corner of the financial system. The result would likely be a sharp increase in uncertainty and a flight from U.S. capital markets.

Because of the significant and unpredictable impact of a default, we are confident that the Treasury will avoid this outcome at all costs. This confidence is shared by most of the analysts we follow, including some of the most pessimistic voices out there.

Path 2: No deal and prioritization

If Congress is unable to come to a deal to raise the debt ceiling, the other option for the Treasury is to continue to make interest and principal payments on Treasury bonds. This would mean that other payments like Social Security, federal aid programs of all kinds and salaries of federal workers would have to be suspended. Basically, all non-essential government functions would have to be curtailed, such as FDA inspections, aid to states, unemployment insurance payments, payments to contractors, etc. In addition, it seems possible that Social Security checks might be delayed as well, although it is not clear whether this is mere rhetoric or an actual possibility.

Since there are no policies as to which payments come first, it’s hard to say which payments would be made and which wouldn’t. However, like a business that has reached the end of its line of credit, the government would be limited to making payments solely out of the monthly tax revenues it receives. The economic impact of this situation will likely be muted in the short-term, as many recipients of government payments will simply delay making payments of their own. However, a great deal of stress will be placed on the economy, as the federal budget of $3.5 trillion is about 25% of all economic activity. Since tax receipts account for roughly 60% of federal spending, reducing spending to receipts alone will eliminate about 40% of federal outlays, or roughly 10% of Gross Domestic Product. So every month that a debt ceiling agreement is delayed would result in roughly a 0.8% reduction in total economic activity, not to mention the uncertainty it would create in spending and hiring plans.

This would likely cause significant volatility in the stock market, though Treasury’s commitment to making bond payments should soothe bond investors. The result should be a ‘traditional’ flight to quality resulting in a drop in stock prices but offsetting gains in Treasury investments.

As disruptive as the prioritization scenario would be, the damage should be relatively short-term compared to the default scenario. We believe this limited government shutdown to be the more likely outcome in the event Congress is unable to reach an agreement on extending the debt ceiling before August 2nd.

Path 3: A deal

There are several possible deals floating around in Congress at the moment, each with different provisions and thus different consequences. From our reading, any deal that is passed is likely to raise the debt ceiling enough so that they don’t have to go through this fight again until after next year’s election. The deal would likely reduce federal spending by more than $2 trillion over the next 10 years. It also seems likely to us that most of the spending cuts will be pushed beyond the 2012 election as well, in order to minimize the economic impact of the budget cuts in the run up to the election.

It’s almost impossible to say what kinds of spending cuts the final package would include, although it is hard to imagine cutting that much out of federal spending without impacting all government programs, including Defense, Social Security and Medicare.

In the current climate, it is possible that an agreement could still be reached, though there are significant long-term political and social trends that are actively impeding the politicians coming to any kind of agreement. These were laid out very succinctly in a Wall Street Journal article on July 26th by Gerald Seib. He noted that the undecided debate over the size and role of government in the economy, combined with increased polarization in the House and Senate, result in the severe paralysis we’re witnessing today. The most obvious reason cited for the polarization is the gerrymandering of ‘safe’ districts in which representatives of both parties win elections in the primary, as opposed to the general elections. Mr. Seib points out that this creates “a system in which lawmakers increasingly are rewarded for hewing to the party line and are punished for deviating from it.”

When there is a deep, fundamental and philosophical disagreement between two sides and those who negotiate and compromise are accused of heresy, it is very difficult to find a middle ground that both can agree on. That said, it is also important to remember that an essential step in the Washington negotiating script is the next-to-last-step before any significant compromise is reached. That is the “they’ve never been farther apart” stage just before the eleventh hour deal is reached.

Even at this late stage, we remain optimistic that some compromise will be negotiated avoiding the more dire outcomes outlined above.

Investment Implications

Getting down to brass tacks, the fundamental question is “what is being done in my portfolio” to insulate it from the more negative outcomes?

Remember that earlier this year, we shifted some funds out of traditional bond investments to investments we believe provide better defense in the event of a sharp increase in interest rates. Since a sharp rise in interest rates is a likely outcome of our worst case-scenario above, this defensive move we have already made should help insulate our bond investments in the near-term.

Under the prioritization scenario (Path 2), we believe that the market impact, though sharp, will be short-lived. It is our expectation that the disruptions caused in the markets will focus Congress’ attention on coming to an accord, minimizing the long-term impact on the values of stocks and bonds. This suggests to us that in the short-term gold could benefit, but that any rise in the price of gold would be quickly reversed once a deal is reached. The same could be said of any drop in value of stocks or bonds. In fact, we could see an opportunity to rebalance and pick up riskier assets at discounted prices.

Under Path 3, any deal will likely have a calming impact on capital markets, releasing upward pressure on interest rates while simultaneously releasing traders to focus on other things like corporate earnings. This removal of uncertainty could result in a short-term rally in the stock market. This will depend on the details of the bargain reached, so any investment ahead of a deal would be purely speculative. Against this backdrop, corporate earnings have been generally solid, supporting the probability that a deal on the debt ceiling could ease some of the recent downward pressure on stocks. It would probably result in a fairly significant drop in the price of gold, which many investors have used as a safe-haven alternative to bonds and cash.

The worst-case scenario is clearly default. Even a short-term default would likely result in a permanent upward shift in interest rates, possibly even resulting in efforts by the Federal Reserve to soften the blow through additional quantitative easing. It seems that the only investment likely to prosper in this scenario would be gold. However, because this is also the lowest probability scenario with the most unpredictable outcomes, we cannot recommend that investors make significant changes to their investment portfolios.

In the end, we must caution you to be prepared for additional volatility and frustration as negotiations continue. Unless the country defaults, however, we do not feel that there will be significant long-term impacts as a result of the current impasse. Finally, we cannot emphasize enough that we feel a default is the least-likely of the three scenarios to occur.