Episode 1 – The Debt Ceiling

Hello, everybody. Thank you for tuning in to Market Musings, a Mercer Advisors podcast where we provide a data-driven, common-sense perspective on the economy, on markets, and on investing. I’m your host, Don Calcagni, Chief Investment Officer at Mercer Advisors.

Today, we’re going to focus on the debt ceiling. Obviously this is a big issue, been dominating the headlines, and will likely continue to dominate the headlines and be front and center on the minds of market participants until such time that Congress and the White House arrive at some sort of agreement to either suspend or to lift the debt ceiling.

So let’s first begin with an exploration of, what is the debt ceiling and what purpose, in theory, is it supposed to serve–

why does it exist in the first place. The first thing to know is that the debt ceiling is a legal limit on the total amount that the US federal government can borrow to finance federal government spending.

Current debt limit is $31.4 trillion, roughly, and that’s currently about 120% of GDP. That is the highest that our debt to GDP ratio has been since the Second World War. So it is certainly elevated. It has increased significantly over the past several years, largely in response to COVID-related spending.

The crux of the issue here is that Congress has essentially passed two contradictory laws. The first is the debt ceiling. The debt ceiling was originally passed in 1917. So it’s been in place for over 100 years. It arguably conflicts with the 14th Amendment, which claims or states, I should say, that US government debt shall not be questioned.

And so here, we are. We’re in this weird place where we have a limit on the amount of debt that the US federal government can issue. But at the same time, the 14th Amendment makes the value of US government debt sacred, that it shall not be questioned. So that’s one issue, is that Congress has put a debt limit in place to begin with.

Now, on the other hand, the Constitution also dictates that only the Congress shall determine spending. Congress controls the purse strings. So it’s certainly contradictory that here we are, we have a Congress that sets tax policy in terms of revenues and revenue collection, but also establishes spending policy.

And so Congress actually spends the money. And then at the same time, they have this debt ceiling in place that says they’re not allowed to borrow to pay their bills. So they basically ring up the credit card, but then subsequently they have this debt ceiling that says they’re not allowed to borrow to pay their bills.

So the fact that you have Congress making spending and taxing decisions, that’s one body of law or actually multiple bodies of law, and then at the same time having a debt limit in place, those are inherently contradictory. At the same time, you have the 14th Amendment, which states that US government debt shall not be questioned.

So we’re in this weird place legally where you can even argue potentially, and some scholars have made this argument–

I am not a legal scholar–

but there is a debate over whether or not the debt ceiling is even constitutional. And so it’s just an interesting place that here, we are. The Congress has voted and approved for spending. They’ve also voted and approved for tax cuts.

Tax cuts, logically, are a form of spending, no matter how you look at it. If you vote for tax cuts, what you are voting for is to increase the deficit. That’s exactly how that works. It’s really a matter of simple arithmetic. So I’m not blaming either party here. I’m just highlighting that we’re in this weird place where the debt limit and congressional spending and tax policy are ultimately at odds with one another.

So why is achieving a balanced budget so painfully difficult? You would think, well, gee, if we had a balanced budget, then perhaps this debt ceiling issue wouldn’t be an issue, to begin with. It wouldn’t be an issue at all. Well, the reality is, is that about 50% of all federal spending is on cherished entitlement programs like Social Security, Medicare, and Medicaid.

If we add defense spending to the mix, that puts you at around 65% of all federal spending just goes towards those four programs alone. And then when we add in the interest on our debt, over 70% of federal spending goes towards just those basic five expenditures–

Social Security, Medicare, Medicaid, defense spending, and the interest on our debt.

Why is that number important? Well, you would have to cut everything else out of the federal budget to essentially balance the budget. So you’d have to cut environmental protection, education spending, air traffic controller budgets.

You would have to cut a wide range of government programs in order to just balance the budget, assuming you didn’t want to cut any of those programs. And so obviously, this is why we have elections. And this is why we send our elected representatives to Washington.

So I just highlight that because I think it’s important to understand that balancing the budget is much easier said than done. It makes for a great political soundbite, but mathematically is actually exceptionally difficult to do when you consider how our federal government spends the dollars that it collects from all of us as Citizens.

Fast forwarding to the immediate current situation, where do we stand? When does it look like the federal government might potentially run out of funds to pay its bills? We call that the X-date. That would be the date when we believe the Treasury would no longer have the cash it needs to pay all of its bills.

And Moody’s Analytics, which is a consulting firm that we follow quite closely here at Mercer Advisors, they estimate that the X-date for the US Treasury to be somewhere around June 8. So if you’re following this issue in the headlines, you’ll see that this X-date tends to vary between June 1 or sometime into July.

There’s a lot of variation around when exactly we think the Treasury would run out of money because the collection of tax revenues is very, very hard to predict. In fact, tax revenues relative to this time last year, from data that I just reviewed from Moody’s Analytics, are running at about 40% below where we were this time last year.

A lot of that’s due to the fact that we had stock market losses last year. A lot of investors harvested capital losses, and things like that ultimately are good for taxpayers individually because that allows us to deduct some of that against our income, and so on and so forth. But that naturally has an impact on what the Treasury collects in the form of tax revenues.

So there’s a lot of variation around exactly when this X-date will fall. Treasury Secretary Janet Yellen has said that June 1 is the earliest that she believes that the Treasury could run out of funds. So hence the pressure is on. You see that in the headlines just recently today, the pressure is on for the White House and for Congress to cut a deal and either suspend or increase the debt ceiling.

So what is Mercer’s view? What is our base case? Do we even think, to begin with, that the federal government is going to default? Our base case specifically, what we expect is that the Congress and the White House will eventually reach an agreement. It’ll probably be at the last minute.

But I have to believe that representative McCarthy, President Joe Biden, neither party, neither of those two individuals, wants to take the US over the cliff and experience a first ever default on US government debt.

So our base case at the moment is we fully expect that both sides are ultimately going to come to an agreement, but that doesn’t mean that it’s going to be a smooth process. We certainly expect a lot of last-minute brinksmanship, lots of political theatrics, certainly a lot of soundbites from representatives of both parties, and certainly some market volatility. We expect all of that before an agreement is reached.

We’ve seen some market volatility this week, both on the downside, also on the upside when it sounds like perhaps they are getting closer to a deal. Markets tend to rally, and certainly vice versa. All of that said, that is our base case. We do expect there to be an agreement.

But that said, there remains a growing possibility, in our view, that lawmakers might–

and I emphasize–

might fail to reach an agreement in time and that that would result in what we call a TARP-like moment. That is a reference to Congress’s initial failure in October 2008 to pass the Troubled Asset Relief Program that was part of the Economic Stabilization Act to combat the global financial crisis in early October.

And what happened is when Congress failed to pass TARP, the markets violently reacted. We saw, I think, about a 13% sell off over several days, and Congress quickly reversed course.

And so in the event that there is a default, I think that that is a higher probability outcome where Congress members would be scared straight. They would see that the markets are reacting negatively to their failure to come to an agreement. And I think that between the White House and Congress, that they would quickly come together, close ranks to get something passed.

That seems likely. There is historical precedent for that, not for a debt default, but for situations where Congress and the White House failed to act, failed to come to an agreement. Markets did not respond well. And yet, subsequent to that initial failure, they closed ranks, passed some legislation, and ultimately moved us to a better place.

If the US does default, what do we think the market and the economic repercussions will be? I get this question a lot–

how bad will it get in the event that we experience a debt default, and perhaps that default lasts for a somewhat prolonged period of time? Maybe it’s not a TARP-like moment. Maybe they default for a period of time, maybe several weeks, or perhaps even a little bit longer.

And our view is that–

and by the way, we’re borrowing a lot from Moody’s Analytics research on this particular topic, and that research is in the public domain. You can go unlined, google Moody’s Analytics, and you’ll see that they have a lot of different research that they’ve put out there.

But should lawmakers come to an agreement to suspend or increase the debt limit, Moody’s estimates that the economic and market impact would be very, very severe. They estimate as much as 8 million jobs would be lost. They also estimate about a 5% decline in gross domestic product. And just to give you some context, that’s on par with the decline in GDP that we experienced during the global financial crisis back in 2008, 2009.

They also estimate that we would experience about a 20% decline in stock prices. They also predict that interest rates would spike on everything from home mortgages, credit cards, student loans to payday lending services. So the costs to all of us as citizens would be quite dramatic.

It would also make it more expensive for the Federal government to finance its debt, since the federal government is not immune to developments in financial markets. They borrow capital from financial markets. So the expense that we all pay as citizens, as taxpayers to finance federal government debt would also increase.

And, in fact, Moody’s projects that by 2030 that the US’s debt to GDP ratio would actually be about 16% higher with a default than would be the case without a default on US government debt. So perhaps ironically, I know part of the mission here for deficit hawks is to rein in government spending. Yet if they were to take the federal government into default, it would actually exacerbate the US federal government’s financial position, at least according to Moody’s Analytics.

Additionally, and this will be my last point on this, the value of the US dollar globally would also decline. It would then be clear to global financial market participants, to global investors, that the US dollar and specifically US government debt is no longer a safe haven, or I should say, as much as a safe haven as it once was.

So there will be a risk premium. That’s how financial professionals think about this. There would be a risk premium. There would be a higher interest rate now that the US government would have to pay to borrow in financial markets, but additionally, the value of the US dollar would decline.

And that would also put some downward pressure on what at least until now, is the world’s preferred global reserve currency. The dollar is by far the world’s most highly preferred reserve currency, but that would put some downward pressure on other central banks, other investors to hold US dollars as a safe haven asset.

I’m just painting a picture for our listeners around how bad could it get in the event of a debt default. That’s not base case. That’s certainly a fairly draconian picture of what the economic and market impacts might be in the event of a debt default, but that is not our base case. We still expect that there will be an agreement that the US government will not default.

So what is Mercer Advisors doing to prepare for the unlikely possibility of a US government debt default? Quantifying the probability of a default is certainly challenging. I think you heard that here over the past several moments, but it’s also really hard then to subsequently tie that to an investment thesis.

So what I would say is it’s not entirely clear that there’s an obvious investment solution given the uncertainty around a US government debt default. We continue to closely follow negotiations. We are exploring the different default scenarios. What could they look like, how bad would it be, and what can we do to further diversify portfolios and perhaps somehow make sure that our portfolios would come through that as best as could realistically be expected.

At this time, like I said, there is not a clear, obvious answer. Some folks come to us and say, well, why don’t we go to cash? Well, going to cash to own US dollars, which is the currency issued by the US federal government, which is planning to default, does not make a lot of sense. You would not want to own the currency of a government that is in default. So simply liquidating everything going to cash, not a realistic solution when we look at it through that very simple common sense lens.

Other folks might suggest things like Bitcoin or gold or something like that. We don’t think those are good solutions. Those are very volatile assets. They don’t produce any cash flows. So if you think of stocks and bonds and real estate and things like that, those are assets that produce cash flows. And at the end of the day, as investors, cash flows are really what you need in order to appropriately value an asset.

Gold is highly volatile. If you just look at the history of gold prices, they tend to be very volatile. So if you’re thinking to yourself for a moment, OK, I own short-term high quality bonds, maybe those are treasuries. What would be the next best, quote, “safe haven asset?” I think there’s a lot of distance between treasuries and gold and certainly Bitcoin which has no tangible value.

There’s really no evidence that gold or Bitcoin or something else, or perhaps a commodities basket would be an appropriate safe haven alternative to a good old-fashioned sleeve in a portfolio of high quality investment grade bonds. So we still stand behind that thesis that it makes sense to own high quality bonds. You want those bonds to be relatively short duration in your portfolio.

So said differently, you don’t want to be lending out your capital by purchasing 20-year or 25 or 30-year bonds. We prefer very short-term bonds at the moment, but we think there’s still a strong case to be made for owning short-term, high-quality bonds, instead of dabbling in some of these more highly volatile assets that have questionable value.

Another point that I would make that I think is important for all of us as investors and as asset managers to keep in mind is that in the event that there is a default by the US government on its debt, that would be due purely to an unwillingness to pay its debt and not due to an inability to pay its debt.

Being unwilling to pay our debt is not the same as being unable to pay our debt. So very, very different. No one seriously questions the US government’s ability to cover its debts or to pay its bills. The US government can obviously increase taxes at its discretion. Certainly, we need Congress to approve that. That’s not like the president has control over that.

But the US government has substantial assets, substantial revenues, and it continues to be considered the world’s safest borrower by far. So certainly they have the means. And so they certainly have the ability to pay their bills. This is an unwillingness to pay our bills out of concern over government spending, perhaps getting out of control or being too elevated.

To take things a step further, there’s this question around, what should investors do, perhaps to prepare? And I’ll finish on this point, is what should investors do to protect themselves and their personal financial situation in the event of a government default? And I think first and foremost is you have to go back to the basics.

Portfolio diversification is, at its core, a risk management tool. The cause of market volatility will change from time to time. Last year, we saw significant market volatility due to Russia’s invasion of Ukraine, rises in interest rates, and a host of other issues slowing GDP growth, things like that. This year, the debate around the debt ceiling is what’s driving market volatility.

How do we protect, how do we manage our portfolios through market volatility? We do that through broad global asset class diversification. And by that, I don’t mean owning 5, 10 or 30 stocks. I mean owning thousands of companies, thousands of stocks, thousands of bonds globally, not just in the United States.

This whole debt debacle is evidence as to why we should be globally diversified, owning assets that are denominated in something other than US dollars, owning high quality European companies, high quality Japanese companies or Australian companies, and emerging market companies in rapidly growing markets. So owning non-US assets is a powerful tool for helping to protect our portfolios against perhaps threats to the value of the US dollar.

So first and foremost, remaining well diversified. So revisiting these first principles of investment success. Number one, portfolio diversification. Number two, controlling costs is critically important. One of the challenges that I have with a lot of these investment products that are being sold by many financial institutions these days are very expensive, very complex.

And there’s a lot of products out there claiming to give you the upside with no downside. And we vehemently object to those types of products. We think the cost can be quite high, and oftentimes they are very opaque and very difficult to understand.

Third, we would strongly recommend that investors always revisit their risk tolerance and their financial plans. If you are uncomfortable with market volatility, if you are worried about the impact of a prospective US debt default on your financial situation, you should certainly meet with your advisor to revisit that. And make sure that your personal asset allocation reflects your family’s need, tolerance, and capacity for investment risk.

And so having that trusted advisor, working with that trusted advisor to revisit your portfolio, to revisit your financial plan now is as good a time as any to meet with that individual and make sure that you are in a good position to weather through any storm that’s caused by what’s going on in Washington.

I think my final point, and I’ll end on this point, it’s important to make sure that we always have appropriate emergency reserves set aside. Putting aside a certain amount of cash, a certain amount of monthly expenditures. Talk to your advisor about what the appropriate amount is–

is it six months, is it 12 months, is it 18 months?

That is a personal decision. Everybody’s answer to that question is going to vary, but it is important that we do have appropriate reserves set aside in the event of some unforeseen circumstance that might derail us financially, perhaps a job loss, perhaps a health event or something along those lines. So making sure that we have appropriate cash reserves is always critical.

And I think if you do those things–

portfolio diversification, keep costs low, working with a trusted advisor, revisiting your risk tolerance and making sure you have an appropriate cash reserve–

if you’re doing those things, you are better positioned than most when it comes to weathering through a very unlikely, but still yet possible US debt default.

Well, that’s all for today. Thank you for listening to Market Musings, the only podcast that provides a data-driven, common-sense perspective on the economy, on markets, and on investing. I’m Don Calcagni with Mercer Advisors, and we look forward to seeing you next time.