Key Questions: Will the Debt Ceiling Debate Cause a Market Debacle?

Investors shouldn’t become overly fearful of a market debacle, but they should be more discerning.

In the first 140 years of our country, Congress employed a targeted approach to managing our nation’s debts. Under Article I, Section 8 of the US Constitution, debt issuances were authorized by Congress for specific projects, such as bonds issued to finance the construction of the Panama Canal. Similarly, a few years later, during the Spanish-American War of 1898, Congress permitted the Treasury secretary to issue debt with specific limits on maturities. But World War I proved to be a tipping point: It was a conflict with immense and unknowable costs, making targeted legislation difficult and impractical.

In the First Liberty Loan Act of 1917, Congress established a $5 billion limit on new bonds, along with the issuance of $2 billion in one-year "certificates of indebtedness." However, a revision was quickly needed. The Second Liberty Bond Act of 1917 permitted Congress to set a broad limit on borrowing: $9.5 billion in Treasury bonds and $4 billion in one-year certificates. This legislation granted more freedom to the Treasury secretary to determine the optimal mix of securities to issue and with much less congressional oversight than before.

By the end of World War I, the limit on Treasury obligations had been raised to $43 billion, greatly eclipsing the $25 billion in outstanding public debt at the time. From that point until 1939, increases in the national debt were simple amendments to the Second Act of 1917. Just before World War II in 1939, however, Congress adopted an aggregated national debt limit. The debt limit was originally conceived as a way to make things easier for Congress because circumstances might arise that could not be quantified or predetermined. But because some oversight was still desired, the debt ceiling was born.

The debt ceiling is the national debt limit that the US Treasury can incur, putting a ceiling on how much money the federal government can pay on existing debt, much like a credit card. It does not directly limit government spending because expenditures are authorized via separate congressional legislation. However, it can restrain the Treasury from paying for expenditures after the limit has been reached.

If the debt limit is not increased, then the government’s credit is effectively "maxed out," and the government is considered to be in default of its financial commitments.

In the post-World War II era, concerns over escalating debt ceilings forced intense debates over federal budgets and spending. And while Congress raised or suspended the debt ceiling about 80 times since 1960, in recent years, such debates have seemingly become far more politicized with one political party using the debt ceiling — and the specter of a government default — as bait to compel the other political party to agree to things they otherwise might not accept.

In 2011, for instance, Republicans (who had retaken the House of Representatives the prior year) offered to raise the debt ceiling provided that then-President Obama would accept significant spending cuts in the future. As the impasse grew throughout the summer, stocks swooned, ultimately reaching a crescendo in early August when the credit-rating agency Standard & Poor’s (S&P) downgraded the credit rating of the US, effectively no longer viewing US debt as the ultimate "safe haven" asset.

What people might have forgotten about this episode is the fact that an agreement between President Obama and congressional Republicans to raise the debt ceiling was reached before S&P’s actions. Still, S&P made a bigger point by citing an ineffective, unstable, and unpredictable political system as the rationale for its action. In other words, its concerns centered not on America’s ability to pay but rather its willingness to pay amidst intense political discord.

Fast forward ten years to today and we face a similar set of circumstances: a looming debt ceiling limit, heated debates over budget deficits and spending programs, and a deeply divided government. Accordingly, cries over financial calamities are again ringing out. Writing in an op-ed to The Wall Street Journal, Treasury Secretary Janet Yellen recently cautioned that failing to raise the debt ceiling would have dire consequences: "Our current economic recovery would reverse into recession, with billions of dollars of growth and millions of jobs lost. We would emerge from this crisis a permanently weaker nation," she warned. These are things not to be taken lightly.

"Our current economic recovery would reverse into recession, with billions of dollars of growth and millions of jobs lost." — Janet Yellen, US Treasury Secretary

Last week, Congress agreed to extend the debt limit by roughly six weeks so that debate on various spending proposals could continue. Concluding that a crisis has seemingly been averted, stocks rose on the news. With that said, six weeks isn’t very long, especially when considering the significance of other issues being debated and the divisiveness that surrounds them, coupled with practical matters such as holidays. Moreover, as one political pundit quipped, "The only thing harder than raising the debt ceiling limit once is raising it twice."

It would not surprise us, therefore, to see market volatility persist in the weeks ahead. Such may manifest itself as companies begin discussing third-quarter results this week, results that were likely impacted by some slowdown in revenues due to concerns over the Delta variant and rising cost pressures brought on by supply chain challenges.

Still, while political dysfunction will most assuredly persist, we believe the debt ceiling will ultimately be raised or extended, although it may not happen before the newly established deadline occurs. Likewise, rising cost pressures stemming from supply chain bottlenecks may also persist longer than desired.

But both dynamics — political dysfunction and supply/ demand imbalances — should wane over time. And for this reason, while we don’t think investors should become overly fearful of a market debacle, they should become more discerning over what they own and know why they own what they own.

For more information, please contact your advisor.