Debt and Dysfunction in Washington: The US Hits the Ceiling (Again)

As Washington begins to address the debt ceiling, what should investors be watching?

What You Need To Know

The degree of polarization and mistrust between the two major parties in the US, coupled with a narrow Republican majority in the House, pose a worrisome backdrop ahead of the upcoming debt-ceiling negotiations.
Both parties recognize that the consequences of doing nothing could be catastrophic for the US economy, not to mention the global economy and financial markets.
The prospect of a Congressional impasse could stoke market volatility in the short term, but we expect the debt ceiling will eventually be lifted.

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The US has maxed out its borrowing again, with the $31.4 trillion debt ceiling coming onto investors’ radar as a potential tail risk for markets. No wonder: Memories of S&P’s 2011 downgrade of US government debt and federal government shutdowns in 2013 and 2018 suggest that partisan brinksmanship and rancor, culminating in another 11th-hour patchwork deal, are probably what we should expect from Congress this time around.

For added color on the political showdown in Washington, I recently spoke with Wellington’s US Macro Strategist Mike Medeiros.

Mike, what should we be watching closely here?

The US debt ceiling is a critically important issue, not only in Washington, but also for the global economy and markets. Failure to raise it in a timely manner could result in significant negative fallout, from default to downgrade and more.

The US Treasury has said that June 5, 2023 is the earliest possible date (the “X date”) for when the government could default on its debt obligations. While default is not my base case outcome, there are enough red flags to warrant investors’ attention, given the potentially serious risks of Congressional inaction. In the current US political environment, the degree of polarization and mistrust between the two major parties, coupled with a narrow Republican majority in the House, pose a worrisome backdrop ahead of the upcoming debt-ceiling negotiations.

What is the likeliest path to a solution, in your view?

The distribution of potential outcomes remains wide, and my level of concern around the process of raising the debt ceiling is elevated. I think a Congressional agreement to form debt-sustainability committees on a bipartisan basis is the most likely path and is currently being discussed in the Senate. The key would be whether these committees have any binding constraints, particularly, a clear timeline with deliverables to ensure that the debt ceiling actually gets raised in a timely manner.

There are other possible paths: 1) One side “gives in,” with either Republicans agreeing to an unconditional debt-ceiling increase or Democrats acquiescing to some discretionary spending cuts; or 2) President Joe Biden raises the debt ceiling through executive order if, for example, Congressional negotiations fail and push the US government to the edge of default.

What are the odds of the US breaching its debt limit?

The market has assigned fairly low odds to a US government default, which makes sense to me given that there have been numerous debt-ceiling increases since 2011. Both parties, Democrats and Republicans alike, recognize that the consequences of doing nothing could be catastrophic for the US economy, not to mention the global economy and financial markets. That’s obviously an undesirable outcome for which neither party would want to take responsibility, especially come election season. However, the stakes are much higher today, with US public debt now 127% of GDP. As FIGURE 1 shows, that’s more than double what it was in the late 1990s.

FIGURE 1

US Public Debt Relative to GDP Is at Record Levels (1932-2021)
US Public Debt as a % of GDP

Note: Shaded areas are periods over which there was a significant rise in the US debt as a percentage of GDP. Supply-side era represents a period of large tax cuts and less government regulation. Data Sources: Haver, Congressional Budget Office.

My Base Case and Investment Implications

With Mike’s valuable perspective on the US debt ceiling, my base case as of this writing is that the prospect of a Congressional impasse could stoke market volatility in the short term, but the debt ceiling will eventually be lifted (aided by mounting public pressure to do so). For now, I see several potential investment implications:

Higher credit-risk premium on US government bonds: Waning investor confidence in a timely resolution of the debt-ceiling quagmire may be reflected in a steeper US yield curve.¹ Whether interest rates would rise (due to a larger credit-risk premium), or fall (given higher recession risk) is less clear.
A weaker US dollar, a potential boon for non-US risk assets:² A perception that the US government is unwilling or unable to pay its debts would be a weaker currency story for the US dollar and could support non-US risk assets. That said, the US dollar remains the world’s dominant reserve currency, with global central banks holding around 60% of their reserves in greenbacks.
Defensive sectors could potentially outperform: Increased recession risk may benefit more defensive equity sectors, such as healthcare, utilities, and consumer staples.
Upside for gold: A weaker US dollar amid a debt-ceiling battle in Congress could be supportive of gold prices, at least temporarily.

The views expressed here are those of the authors and Wellington Management’s Investment Strategy Team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

Talk to your financial professional about how you can help position your portfolio for potential market volatility.

¹ Yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes.

² Risk assets refers to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies..

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. Investments in commodities may be more volatile than investments in traditional securities. • Investments focused in specific sectors may be subject to increased volatility and risk of loss if adverse developments occur. • Different investment styles may go in and out of favor, which may cause an investment to underperform the broader stock market.

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About The Authors

Nanette Abuhoff Jacobson

Managing Director and Multi-Asset Strategist at Wellington Management Company and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

Michael Medeiros, CFA

US Macro Strategist at Wellington Management