Market Commentary - 10.10.13
Avoiding a Debt Ceiling Catastrophe
While we are seeing tentative signs for a short-term breakthrough to increase the debt ceiling, no long-term grand bargain or agreement to reopen the federal government has yet occurred. Should entrenched differences persist, this discussion reviews the issues involved and their implications.
Congress controls the government's "purse strings" by authorizing spending. When spending is not fully funded by tax collections, the government must borrow by issuing Treasury debt based upon the faith and credit of the United States. Beyond authorizing the budget, Congress also sets the statutory debt limit â€“ the amount the Treasury Department may borrow to help pay its bills and obligations as agreed to by Congress. To that point, Treasury Secretary Jack Lew said the current limit was reached on May 17th and officials began implementing "extraordinary measures" to adjust and shift balances to continue paying the government's bills. Secretary Lew warned that on October 17th, the Treasury will exhaust any remaining flexibility these measures offer and therefore urged Congress to raise its debt ceiling.
According to the Congressional Research Service, lawmakers have increased the debt ceiling 77 times since 1962, 15 of them since April 1993. The Wall Street Journal reported that of past debt ceiling increases that were tied to other spending alterations, 60% occurred during Democrat-led Congresses, 15% during Republican-led Congresses and 25% during divided ones â€“ as is the case today. Should the debt ceiling be increased, as is widely expected, it will mark the fourth increase since President Obama took office. Over the past five years, the debt ceiling has been increased from $11.315 trillion to $16.699 trillion, including extraordinary provisions. Fiscal issues surrounding the last debt increase in 2011 prompted Standard & Poor's to lower its U.S. credit rating for the first time (AAA to AA+), but the ratings agency has since upgraded its outlook to stable from negative.
The federal government is now at a crossroad, and global markets hang in the balance. If a resolution is not found soon, the economic and market impact of the impasse will rapidly increase. If Congress refuses to raise the limit, there is a risk the U.S. could face its first ever debt default. In particular, the Treasury would not have enough cash on hand to make a scheduled Social Security payment of nearly $25 billion on November 1st. It would also likely be unable to meet a debt interest payment of roughly $30 billion due on November 15th, potentially triggering a default. Intense market uncertainty would likely ensue, causing riskier assets to be sidelined, and a rush into Treasuries could spark a sharp drop in yields. Still worse, protracted uncertainty may severely dampen consumer spending and business investment, endangering investor sentiment and fourth quarter GDP growth. With uncertainty in Washington and its potential effect on the economy, business leaders may also be reluctant to hire additional workers â€“ clearly not a good sign for a still fragile economy.
All parties want to avoid default by raising the limit, but entrenched political ideologies are clashing. Republicans want to negotiate reductions in federal spending, including defunding or delaying implementation of President Obama's signature healthcare reform measure, the Affordable Care Act, known as Obamacare. Led by insistence from the President, Democrats refuse to negotiate and instead urge Republicans to ignore past precedence and pass the Democrat-led Senate legislation.
During the last government shutdown 17 years ago, the 28-day debt and budget battle caused the S&P 500 Index to slump less than 4%, but quickly recovered to gain more than 10% in the month following the resolution. However, economic conditions were much healthier then versus now, particularly with regard to bond yields and the unemployment rate. At the end of 1995, the 10-year Treasury yielded 5.7% compared to 2.6% today, and the jobless rate was 5.6% compared to 7.3% today. At the very least, this means investors should expect a heightened degree of market volatility, going forward until we reach an eventual resolution. We reiterate our call to increase portfolio diversification, and, within equities, to begin shifting from domestic large-cap into international developed markets. Within bond markets, we favor spread product, including corporate bonds, which generally pay a higher yield than comparable maturities in Treasury securities.
This information compiled by Cetera Financial Group is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.