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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.
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.
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.
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