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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


What the Looming Debt Ceiling Deadline Means for Investors

From an email sent to IIM investors on May 8, 2023…

The federal debt limit is once again in the news as the country approaches a critical deadline on June 1. Investors are understandably nervous about Washington failing to reach an agreement, a possibility that both sides agree would be a self-inflicted catastrophe. While it’s unclear exactly how this will play out in the coming weeks, the fortunate news is that financial markets are mostly taking these events in stride so far. Here are some thoughts that might help maintain perspective around this specific uncertainty as the deadline approaches.

First, it’s important to understand what the debt limit is – and what it is not. In simple terms, the federal government borrows money to pay its bills by issuing Treasury securities. That’s necessary because the federal government usually operates in a deficit – when spending on things like defense, Social Security, and emergency pandemic stimulus exceeds government revenues, made mostly of tax revenues. While tax revenues increase as the economy grows (even without raising tax rates), they have been outpaced by spending over time. The difference must be made up by borrowing, which adds to the national debt – and which hit the $31.4 trillion debt ceiling in January. Since then, the Treasury Department has been employing what it calls “extraordinary measures” to ensure that the country does not default on its obligations.

Federal borrowing reached the debt limit this past January

The debt ceiling is a mechanism that requires Congress to approve additional borrowing above these levels. What can make the discussion confusing is that the debt ceiling is not about government spending per se. That spending has already been authorized – through the normal budget process, that takes place each year.

The only real question around the debt ceiling is whether the government can and should pay its bills. For most of us, the decision to buy something can’t be separated from whether or not we will pay for it. Unfortunately, the Congressional process for approving a budget by September 30th each year is separate from whether the Treasury can actually pay the bills.

Near-term Treasury rates have jumped but longer-term rates are steady

Second, the large and ever-growing national debt is a controversial topic that impacts the economy and markets in complex ways. At the moment, Democrats, who control the White House and Senate, and Republicans, who control the House of Representatives, are in a standoff. On April 26th, the House passed a debt limit bill by a narrow vote margin of 217 to 215. This would increase the debt limit through March 31, 2024 or until the national debt increases by another $1.5 trillion. However, it also includes provisions such as discretionary spending limits, the repeal of renewable energy tax credits, increased work requirements for benefits programs, and a few other new proposals. That bill is politically fraught, so it’s unlikely to pass the Senate and be signed into law.

As usual, there is plenty of political grandstanding and intentional drama around this issue. Similar debt ceiling standoffs have occurred a number of times of late, with the limit suspended and raised in 2013, 2014, 2015, 2017, 2018, 2019 and 2021. According to the Congressional Research Service, the debt ceiling has been raised 102 times since World War II.

Fortunately, despite the headlines and investor concerns, this political drama has little long-term impact on markets. The U.S. has never defaulted on its debt, and nearly all economists and policymakers agree that doing so now would lead to turmoil in the financial markets and increase borrowing costs for businesses and everyday citizens. That risk is evident in the bond market with a sharp jump in Treasury rates with maturities around the debt ceiling deadline, and then much lower rates afterwards.

There has been one exception, though, to markets staying relatively calm. In 2011, a similar standoff led the credit rating agency Standard & Poor’s to downgrade the U.S. debt. The stock market fell into correction territory with the S&P 500 declining 19%. Ironically, the prices of Treasury securities increased during the 2011 debt ceiling crisis, because even though these were the exact securities being downgraded, investors still believed they were the safest in the world at a time of heightened uncertainty. Soon after that downgrade, the debt ceiling was raised, a new federal budget was approved, and markets quickly bounced back.

Income tax rates are still low by historical standards

Third, debt ceiling aside, the national debt at current levels means that it has more than doubled over the past decade, and with very few exceptions has grown nearly every year over the past century. While everyone generally agrees that the government should not spend more than it generates in tax revenues, the unfortunate reality is that neither party has addressed the problem over the past twenty years. The last balanced budgets occurred during the Clinton years and then the Nixon administration before that.

So, deficits are unlikely to go away. And given how heated the topic of government spending can be, it’s important for investors to separate their political beliefs from how they manage their portfolios. In other words, investors should focus on what they can control.

In the long-term, we should also realize that the odds of higher tax rates will likely increase as the national debt continues to grow. Today, the highest income tax rates are slightly above their lows after the Reagan tax cuts – but still far below historical peaks. High-earners in the mid-1940s paid rates as high as 94% on their marginal incomes. Even those in the lowest bracket would have paid 20% or more during the 1940s, 50s and 60s – double today’s rates. U.S. corporate tax rates were also among the highest in the world until the 2017 tax cuts. So, while higher tax rates are not guaranteed, there may be some financial steps you can take today to help protect you from future tax uncertainty. And please let us know if that’s something you’d like to discuss.

The bottom line?

The debt ceiling and federal debt will need to be addressed in the coming weeks. It’s important for investors to separate political frustration from hard-earned savings and investments. History shows that staying invested is the best approach to navigating drama in Washington.

Please let me know if you have any questions.

– Cale