5:44 PM PST
Olympia, WA
As you have probably seen in the news and will likely continue to see coverage of over the next several months, Congress is at a standoff over the debt ceiling… again. It seems like there is a debt ceiling standoff every two years at this point, so it’s nothing new, but is it worth being concerned about? For investors, I would say it’s something to have on the radar as the worst-case outcome could be disastrous, but I believe unless the pieces start to fall toward that worst-case scenario, we shouldn’t be too concerned. Let me elaborate.
First off, since most people likely hear about the US debt situation on the news but might not be well versed in sovereign debt dynamics, let me explain what the US debt is. When the federal government spends money on the various things it finances (medicare, social security, military, discretionary projects, etc.), the money it uses comes primarily from two sources: taxes and borrowing (debt). You can see more details in the chart by JP Morgan below.
The debt that makes up this borrowing is issued by the US treasury department in the form of various treasury securities such as treasury bonds and savings bonds. The total amount of the outstanding treasury securities accumulate over time as the US must issue more new debt to pay off the old debt (essentially like a massive ponzi scheme), resulting in the total debt the US has today. Investors such as ourselves, other individuals and organizations around the world, and central banks buy this debt for various investment purposes. Since the 2008 financial crisis, the US Federal Reserve has been one of the largest buyers of this debt as they initiated their quantitative easing program. Now that inflation has become problematic, they have flipped and are now letting the debt they accumulated roll off their balance sheet. Additionally, previous US debt purchasers around the world such as China and Saudi Arabia are selling their US treasury securities. As with any loan, when there are more lenders than borrowers (as we had in the last decade), interest rates are low, but when there are fewer lenders, those interest rates must move higher to entice new lenders. The US debt dynamics are hugely important because US debt is considered the safest investment in the world, and therefore forms the foundation of the global financial system. Every other investment must target a return higher than the return offered by investing in US debt as an investor could simply buy US treasuries without taking any risk.
This might be surprising, but expanding the debt and running a deficit is generally good for an economy, but it is not without its problems and risks. Debt spending flows into public sector projects, which flows into worker wages, which flows into spending in other parts of the economy, etc., creating a trickle-down effect. However, running a deficit is not without risks and problems. Too much debt can lead to problems such as higher financing rates, currency devaluation, and inflation. In classical economics, the effect of debt spending on the economy is measured by what’s called a fiscal multiplier. When an economy has a high savings rate and a low amount of outstanding debt, every dollar spent by the government can actually produce more than a dollar of economic growth; it has a positive fiscal multiplier. However, when an economy has a low savings rate (like the US) and has debt-GDP above the 40-50% range (like the US), every dollar spent by the government produces less than a dollar of economic growth; it has a negative fiscal multiplier. The chart below by economicshelp.org illustrates the dynamic well.
Ultimately, the US debt is somewhat problematic, which justifies measures aimed at reducing it, but does it justify not raising the debt ceiling? I would argue it is not justified. If the debt ceiling does not get raised, the US could be at risk of defaulting on some of its maturing debt. As US debt underpins the global financial system, this could result in a global financial catastrophe. Realistically, the debt ceiling is a technical rule that serves no real purpose in influencing our federal debt other than to cause a funding wall when it is close to being hit. It would be much more responsible for Congress to have discussions around the debt when forming the budget and other spending bills that flow into the deficit rather than risking default by refusing to raise the debt ceiling for the spending that has already been approved.
As my opinion will have no bearing on Congress’s decision, let’s look at what could happen if the debt ceiling is not raised, at least temporarily. Most calculations I have seen suggest that the US treasury has enough funding until the end of spring, possibly a few months longer. The debt ceiling must be raised by then, or else the US will default on debt that matures in the following months. In this worst-case scenario, I would expect it to be a technical default – defaulting on a few months of maturing debt before the issue is resolved. This seems like it would not be a big deal if it gets shortly resolved, but calculations by RSM suggest that it would still result in an economic disaster, with unemployment most likely going above 7% in this scenario. It would also alter the US’s position within the global financial system.
As an investor, how could you protect yourself from this type of event? I studied what occurred in 2011 to get an idea of what could work in a debt ceiling crisis and what might not work. 2011 was the closest the US has gotten in recent history to breaching the debt ceiling and defaulting on its debt. In 2011, there were fights over the budget and the debt ceiling that dragged out into July. The situation was ultimately resolved on July 29th, but the shenanigans resulted in Standard & Poor’s lowering the credit rating of the US from AAA to AA+. Looking at investment performance during 2011, we can see that stocks sold off near the July deadline. Meanwhile, bonds performed well, and gold had very strong performance before settling back down when the situation was resolved.
If history is any guide, I would expect a similar outcome this time around if there are issues with the debt ceiling. I would expect stocks to sell off as the resulting economic weakness would result in lowered company earnings. Bonds, mainly treasury bonds, I would expect would have fairly strong performance. This would be because the debt ceiling would make it so that there would be fewer bonds issued, hence a lower supply. If the demand side doesn’t change, the lower supply would push the price of bonds higher. Gold, which is viewed as the ultimate store of value, would be the best asset to own in this scenario. In the past, whenever a government has had issues around its finances, gold has always been where people flock to retain the purchasing power of their money. I don’t think it would be any different this time around.
Overall, since the consequences to not raising the debt ceiling are so negative, I see the chances of this worst-case scenario as being very low, but anything is possible. As a risk, this would fall into the category of a known unknown – something we know is a risk, but we don’t know if the outcome will be good or bad. One thing you learn from studying market history is that the known unknowns are usually not the causes of the big market selloffs. It’s the unknown unknowns that do the most damage – the risks that no one is talking about.
Bottom line – diversification is the only free lunch in investing. I believe diversification involves more than just different types of stocks and different types of bonds. If you want protection from various risks and consistency of returns across multiple scenarios, adding other assets such as gold to an investment portfolio makes sense.
