- Macro Strategist
United Kingdom, Professional
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The partisan political divide in Washington over raising the statutory US debt limit (the so-called debt “ceiling”) is back on investors’ radar screens, after briefly falling off amid the banking-sector turmoil that dominated the headlines for most of the past couple months. With those systemic contagion fears having receded, many market participants are refocusing their attention on the possibility that the debt-ceiling standoff could have an endgame similar to what occurred in 2011 — when US politics were arguably less bitterly polarized than they are today.
Here are our latest thoughts on this issue and some of its potential market and investment implications.
As in 2011, things could get messy in a hurry
In 2011, market participants largely priced in a messy US debt-ceiling process and a likely credit-rating downgrade of US sovereign debt (which ultimately happened in August of that year, when S&P for the first time ever stripped the US federal government of its coveted AAA credit rating). At that time, investors’ elevated level of concern manifested itself in the guise of several risk-off market moves: US Treasury yields declined sharply and gold outperformed as many investors sought perceived safe havens, while US equities and other risk assets sold off to varying degrees. To make matters worse, the debt-ceiling fiasco just happened to coincide with the 2011 European debt crisis.
It's hard to say right now if this time around will have a different ending, whether better or worse. In our view, a happy resolution to the drama may require the markets to play the role of “disciplinarian,” so to speak, hopefully pressuring Congress to take appropriate action in a timely enough manner to avoid another credit-rating downgrade or an unprecedented US debt-default scenario. As of this writing, however, we are concerned that the probability of a rancorous and unfruitful political process, perhaps leading to an undesirable outcome, remains high.
Then and now: Today’s grim public-debt backdrop
As we see it, there are two fundamental differences between now and 2011. First, US inflation is obviously much more of a threat today than it was then. Second, the medium-term US public-sector debt backdrop is far worse these days.
- Debt held by the public is currently 98% of US GDP, which the Congressional Budget Office (CBO) projects will rise to 110% over the next decade, driven by unsustainable growth in federal entitlement programs, rising government interest costs, and persistently low revenues — all of which have suppressed more economically beneficial forms of government investment.
- Given ongoing US demographic changes, including a rapidly aging population, the Social Security trust funds’ excess reserves are at risk of being depleted within a decade, which in turn could force reductions in benefit payments by as early as 2033 (barring any changes to the Social Security program before then).
- Historically, given linkages with the private sector, rising US government investment has preceded periods of significant productivity growth across the entire economy. Thus, the lack of beneficial government investment (see above) poses a formidable headwind for broader productivity gains and economic expansion, although components of the US Inflation Reduction Act (IRA), infrastructure bill, and the CHIPS and Science Act should help at the margins.
- From a global geopolitical perspective as well, these trends are worrisome. For example, within the next few years, the US looks poised to shell out more in interest costs as a share of GDP than in defense spending (which, by the way, has historically been a big driver of trend economic growth).
Bringing it back to the US debt ceiling
The medium-term public-debt issues highlighted above are critically important to the debt-ceiling discussion as the structural ability of the US to pay its debts on time continues to deteriorate amid rising government liabilities in the face of a smaller (and shrinking) revenue base. Meaningful reforms to entitlement programs and other steps to restrain costs and/or boost revenues would help but would be very challenging to implement in today’s polarized political climate. Additionally, the US continues to benefit from the reserve-currency status of the US dollar (USD) worldwide, to a large extent masking the country’s declining ability to pay.
However, that global reserve-currency status could come into question at some point if major overseas holders of US Treasuries begin to doubt the ability (and willingness) of the US government to pay, especially given the market backdrop of high US inflation and record-high political polarization. This could be especially true if another “down-to-the-wire” debt-ceiling debacle were to trigger another ratings-agency downgrade and act as a longer-term catalyst for rising long-end yields, a weaker USD, and US equity underperformance versus the rest of the world.
Which brings us back to the here and now with mounting debt-ceiling jitters: As of right now, the extraordinary measures taken by the US Treasury Department will likely be exhausted by early June. Given that tight timing, a short-term extension remains possible, as does a medium-term solution that might restrain domestic spending. My main concern is around the process of getting there and what that might imply for both “animal spirits” in the markets and worries about the US government’s long-term ability (and willingness) to pay.
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Andrew Heiskell
Nicolas Wylenzek