You have likely seen media coverage of the current drama in Washington, D.C. regarding negotiations over the debt ceiling. Given the potential market implications of a deal not being made, our Sandhill Research Team thought it would be helpful to offer our view on the topic.
The debt ceiling is the maximum amount of money, set by Congress, that the government can borrow. The debt ceiling is to the government what a credit card limit is to a consumer. As the U.S. government consistently operates at an annual budget deficit (the last surplus was in 2001), raising additional debt is required to pay for expenses such as healthcare, defense, and infrastructure, among other commitments. When the debt ceiling is reached, Congress faces the dilemma of whether to raise the limit or to cut spending.
The debt limit of $31.4 trillion was reached on January 19th and the Treasury has been using extraordinary measures to pay its bills with cash on hand since then. The Treasury Department now projects that it will run out of funds on June 1st. This projection is somewhat uncertain because the exact timing of tax receipts (i.e. revenue) and spending is difficult to model precisely. Suffice to say, the pressure to get a deal done in the coming days is rising.
If a deal does not get done, there could be serious consequences – including a government shutdown, delayed payments to government employees, or missed payments on treasury debt. The scenario of a “technical default” – where the government misses a payment on its debt, even if just temporarily – would be unprecedented. This is the outcome that would most significantly rattle markets as U.S. debt has historically been considered risk-free.
Raising the debt ceiling is nothing new. Since 1960, Congress has raised the debt ceiling a total of 78 times. The debt ceiling was first put in place during World War I to keep the government accountable for the national debt used to fund the war. The U.S. and Denmark are the only countries that have a debt ceiling that is managed to a set level. Denmark’s ceiling is much higher than its actual debt level, so this phenomenon of recurring political crises is unique to the U.S.
Historically, Congress has routinely raised the debt ceiling with relative ease. However, these debates have become increasingly politicized over the past decade. The 2011 negotiations became quite contentious, and while a resolution was eventually passed, the episode resulted in the downgrade of the U.S. credit rating by S&P from AAA to AA+. The volatility in the stock market was substantial – resulting in a 17% drop in the S&P 500 over a two-week period.
Since then, Congress has used the tactic of suspending the debt ceiling – temporarily allowing the Treasury to supersede the debt limit until an agreement can be reached. This has been done seven times since 2013. With a split Congress, narrower majorities, and differing priorities within each party, a simple resolution has not yet come to pass.
There are real risks associated with the government defaulting on its debt. Most notably, a decline in investor confidence regarding the creditworthiness of the U.S. would lead to sustained higher costs of funding and diminished demand for U.S. debt. Projecting the likelihood or severity of any domino effects of a U.S. default is difficult, but our belief is that the fundamental operations of our portfolio companies would be largely unimpaired by a technical default. While media headlines and rhetoric out of Washington may elicit fear, we do not see the debt ceiling standoff as thesis-changing to our holdings, nor do we feel the need to meaningfully adjust our portfolios to mitigate these short-term risks.
Looking back, the 17% S&P 500 decline in 2011 was short-lived, as the index rallied to finish unchanged for the full year and it returned to previous highs only a handful of months later. In fact, the S&P 500 has had an average annual return of just above 10% since the 2011 pre-debt ceiling crisis peak. It is also important to note that over half of the 17% decline in 2011 came after an agreement was made. In addition to the debt downgrade from S&P, weakening economic data and a worsening European debt crisis contributed to the sell-off.
The current situation will likely unfold as previous ones have, albeit with a higher level of anxiety. We will see either a short-term solution that pushes the issue out to the fall and allows more time for negotiation, or a longer-term solution that suspends or raises the ceiling into 2024. Keep in mind: volatility is a long-term investor’s friend, and if it materializes in the near term, we will look to take advantage as we have in the past – by buying best-in-class stocks at attractive prices.
The Sandhill Research Team
Disclosure: This has been prepared for informational purposes only and does not constitute, either explicitly or implicitly, any provision of services or products by Sandhill Investment Management. Sandhill Investment Management (“Sandhill”) is a registered investment advisor with the Securities and Exchange Commission that is not affiliated with any parent company. Third-party information in this report has been obtained from sources believed to be accurate; however, Sandhill makes no guarantee as to the accuracy or completeness of the information. All statements made regarding companies, securities or other financial information contained in the content are strictly the beliefs and opinions of Sandhill and are not endorsements of any company or security or recommendations to buy or sell any security. These investment strategies have the potential for profit or loss. For a full list of strategy recommendations for the preceding year, please email your request to firstname.lastname@example.org.
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