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It’s mid-September, which means a few things: kids are back in school, football season is kicking-off, and it’s time for Washington to publicly address the federal budget. Most notably, the conversation lately has been about the imminent need to raise the debt ceiling to avoid a government shutdown… or even hint at the dreaded default.
Yet, before we address how these scenarios may – or may not – play out, it’s important to truly understand the debt ceiling. In several presidential administrations, the debt ceiling has been hotly debated, and has made significant headlines. Expressions like “fiscal cliff”, and “government showdown” have been seen in big bold print across the financial trades. Metaphors aside, here’s what you need to know about the so-called debt ceiling.
What is the Debt Ceiling?
The debt ceiling, formally known as the debt limit, is the legal limit on the total amount of federal debt that the government can accumulate. The debt limit was first enacted in 1917 to simplify the borrowing process for the federal government while regulating overall borrowing. When the government gets dangerously close to hitting the debt ceiling, the administration can introduce a bill to raise the limit. This is not some recent thing either. In fact, since its establishment, the debt limit has been raised nearly 100 times1—which averages out to just about every year. Though in recent years, the increases seem to have intensified if not just from sheer magnitude of amount in budget and news coverage.
Why is the Debt Ceiling Important?
The debt ceiling debate usually centers around opposing budgetary agendas between the White House and Congress, and can intensify into a showdown if the two cannot find an agreement. If the dispute over the debt ceiling goes unresolved for long enough, many government agencies cannot operate from lack of funding—what of course is called a government shutdown.
If the debt limit is reached, the government has exhausted its borrowing capabilities, and must use a range of temporary accounting maneuvers to fulfill certain obligations, aptly dubbed ‘extraordinary measures.’ Should the situation persist, the government will eventually default from the inability to make payments on many financial obligations—which could be disastrous for the U.S. Nonetheless, a U.S. government default has never occurred.
Why is the Debt Ceiling Being Debated Now?
In 2015, the Bipartisan Budget Act was passed, suspending the debt ceiling until March 2017. With the debt ceiling now back in effect, the federal government is quickly approaching the current $19.8 trillion threshold, restarting the debate. But, the clock is ticking on a solution.
Up to this point, the federal government has already been employing extraordinary measures so the government can continue operating. But this is only a temporary fix. To add to the complexity, President Trump agreed to legislation that will slightly raise the debt ceiling solely to provide $15.52 billion for Hurricane Harvey relief.2 Also, President Trump threatened a government shutdown if the U.S.-Mexico border wall was not included in budget negotiations, which could make an agreement more challenging to find.
The Congressional budget office (CBO) originally projected that the Treasury will run out of funds in early-to mid-October without an increase to the debt ceiling. With the most recent legislation, the cutoff time is extended to December.
The Debt Ceiling’s Impact on the Markets
A government shutdown’s effect on the market is swift, and far reaching. First, uncertainty of this type will naturally cause the markets to become increasingly volatile. If the government shuts down, nearly 25% of government obligations will go unpaid, hundreds-of-thousands of government employees will be furloughed, and social security payments may be halted. On top of deteriorating confidence, the spending reduction on a consumer level will damage GDP growth. Business owners, also uncertain about the state of affairs, could put major expansions and hiring decisions on hold, also interrupting economic growth.
Government default—the worst scenario of all—has no precedent. Its shockwaves would damage nearly all facets of the U.S. economy. A default would damage the country’s credit rating, and cause worldwide confidence in the U.S. to crumble. A lower credit rating on such a large scale would make the borrowing environment less desirable on a government and consumer level, choking consumer spending—a key component of the U.S. economy. These consequences are just the tip of the iceberg, and would still contribute to a severe market downturn.
Investing During This Period
The risk of a government shutdown can paint an ugly potential picture for the markets, but there is still recourse for investors. The most recent government shutdown spanned just from October 1 to October 16, 2013, and was the longest in history. Counterintuitively, the S&P 500 rallied 3.1% despite the volatility during the shutdown.3
Since President Trump is presenting the border wall as a near-non-negotiable, a debt ceiling agreement may take longer for the White House and Congress come to an agreement, and volatility could arise in the meantime. Yet, we feel that any shutdown will be short-lived. We will, of course, keep close watch over activity in Washington, and its potential impact on both equity and fixed income markets. We feel that it is likely that the debt limit agreement will have budget provisions attached to it, which can also have implications for the market in the longer term.
The debt ceiling—though serious, is one variable in the complex political equation that is taking place in the markets. Our recent insights, Thinking the Unthinkable and The Week Ahead – Rip Van Winkle, touch on investing amid tensions between North Korea and The Trump Administration, and navigating the upcoming FOMC meetings. We will remain cognizant of these and many other market dimensions when making our investment decisions.
Feel free to reach out to your First Foundation Advisor if you have any questions about how to best plan for upcoming market and economic events.
2 CNN, Trump signs hurricane aid, debt ceiling bill, Deirdre Walsh, September 8th, 2017
3 Marketwatch, Should Wall Street fear a government shutdown? Here’s how stocks fared during past closures, Ryan Vlastelica, May 2, 2017