- Chip Rewey
Debt Ceiling Drama?
Debt Ceiling Drama?
The next market worry will likely be the debt ceiling talks. We expect acrimonious headlines to increase in volume into this summer, as politicians and market pundits compete for airtime with successively louder and more extreme talking points. Indeed, the media has adopted the made-for-headlines moniker of “The X-Date” for when the government will run out of spending authority to meet its obligations, a date that is now forecast for the June to September timeframe.
No One Expects a Default
It is our belief, and realistically the belief of everyone, that the USA will not default on its obligations and the crisis will be resolved in the end with an old-fashioned ‘kick-the-can-down-the-road’ solution for a moderate raise for 1-2 years, leaving the battle for after next election. While this band-aid solution will likely settle the markets into the fall, it would not address the growing long-term budgetary problems of the country that are increasingly likely to impact the future investment environment. Although a debt limit increase will likely be reached without a default, given the acrimony in Washington D.C., there is a risk of economic damage from a raucous debate, either from more downgrades or from a global market that could decide to demand higher yields on U.S. Treasury obligations.
There is a Problem and It’s Getting Worse
On August 5th, 2011 S&P downgraded its rating on USA from AAA to AA+, noting “the breakdown in the ability of the Democratic and Republican parties to govern effectively.” In 2011, U.S. Federal spending was $3.6 Trillion, the deficit was $1.3 Trillion, and the Federal Debt was $14.34 Trillion. Today, 2023 U.S. Federal spending is estimated to be $6.37 Trillion, the deficit is estimated to be $1.57 Trillion and the debt on March 31st was $31.46 Trillion. From the August 2011 downgrade, the U.S. debt has grown $17.11 trillion dollars, while total GDP has only grown $10.5 Trillion to an estimated $26.1 Trillion. It is concerning that current political rhetoric demonstrates the Democratic and Republican parties are still not collaboratively working to address the budget deficit.*
It is not only the size of the US debt at $31.46 Trillion that is concerning, but the potential for interest payments to choke government spending. An extra 1% in the weighted average interest rate on the debt represents a whopping $314.6 billion, or about 5% of the $6.37 trillion the U.S. Government expects to spend in 2023. Any increase in long-term yields on Federal debt could serve both to increase pressure on the budget deficit as higher interest payments would be needed, and also to potentially slow GDP growth in future years, as the cost of capital in the economy would likely rise.
Politicians Need to Act, Responsibly
It is time for politicians to act responsibly and move to decrease budget deficits and slow the growth of the Federal debt. While we do not foresee a net reduction in Federal spending, there are 3 likely ways we will see policy makers try to address this issue: 1) Grow GDP which will raise tax revenues, vs. tax rates. 2) Raise tax rates – which could have a tightening effect and slow the economy. 3) Allow moderate inflation - to effectively erode the value of low-rate fixed coupon debt.
While any real compromise will likely involve some combination of all three of these outcomes, from a market perspective, we believe GDP growth is the best solution, something to keep in mind as the Fed “walks the line” to tamper inflation by slowing the economy. The recent trends of reshoring and directed Federal spending to rebuild our industrial base in industries like micro-chips and drugs are good examples growth initiatives that both parties could support. Increased domestic oil drilling remains a contentious, but easy and direct way to increase U.S. GDP.
What Should Investors Do?
Tactically, we think investors should brace for turbulence into the budget talks. The headlines and acrimony that will likely accompany the talks have the potential to impact investor confidence, especially if risks of a further downgrade or higher treasury yields come into play. While these long-term risks are not new, hearing about them in the headlines could lead to emotionally driven selling. However, since avoiding a default is the most likely scenario, investors may want to scour any emotionally driven market weakness for opportunities.
While we always suggest investors keep adequate cash on hand for near-term needs, tactically, holding a little extra cash into the budget debate now may pay off in the opportunity to buy into any resulting market weakness. Our investment philosophy is built with a long-term view of selecting companies where we see i) a sound financial profile and that do not need any near-term capital market financing needs, ii) a compelling long-term investment narrative that can support growth even if taxes and inflation run higher and iii) a discounted valuation that could limit any volatility related price declines.
Emotions are likely to run high through the debate, which could create compelling long-term opportunities from market turmoil. In our view, increasing selectivity and focusing on companies that have the long-term financial strength and growth opportunities to overcome potentially negative long-term pressures is likely to be a better strategy than an across the board ‘buy-the-dip’ mentality. In short, build a strong foundation and look to stay on the offense.
Rewey Asset Management is a registered investment advisor in the State of New Jersey
1 S&P downgrade statement and commentary sourced from: S&P statement on lowering US long-term debt to AA+ | US economy | The Guardian and United States loses prized AAA credit rating from S&P | Reuters
2 Federal Spending, Deficit and Debt data sourced from Historical Tables | OMB | The White House with table data found here hist01z1_fy2024.xlsx (live.com).
3 U.S. GDP Nominal dollars SAAR sourced from the U.S. Bureau of Economic Analysis, via Bloomberg.
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal.