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The debt ceiling is dominating the headlines. Turn on any news outlet and that’s pretty much all that’s being discussed, and it’s nearly all doom-and-gloom predictions. The Federal Reserve’s fight against inflation has become yesterday’s news.
Our intent is not to make light of the situation or downplay the severity, as we fully acknowledge the potentially devastating risks that could emerge IF the situation is left unaddressed for an extended period. While it is tough to find reasons to be optimistic, it’s helpful to use history as a guide since the past can put current events into context.
Since 1960, Congress has acted 78 times to raise, temporarily extend, or revise the debt limit. All told, there have been 22 funding gaps in the federal budget, of which 10 led to the furlough of federal employees.
Due to a legal ruling change in 1980, the government must “shut down” whenever a funding gap occurs. Since then, there have been 10 shutdowns. While that’s a high number, it is important to note that half of the shutdowns ended in less than three days (1980, 1981, 1984, 1986, and 1990), and only three were longer than two weeks (1995-1996, 2013, and 2018-2019). Only ONE lasted more than 30 days (2018-2019).
The U.S. government hit the current legal $31.4 trillion debt limit in January, and the Treasury and the Fed have since used various accounting measures to keep things moving along. The stakes go up if the debt ceiling is not raised or extended by June 1.
There seems to be some confusion about what happens if a deal is not in place by then. In this instance, the U.S. would hit the debt ceiling but would NOT immediately default. There is a big difference between the two.
The U.S. Treasury would prioritize paying its debt obligations while attempting to reduce its discretionary expenditures. While this could be a manageable scenario over a short period, anything over a few weeks would likely spark chaos in markets, leading to higher borrowing costs for the U.S. Treasury and a potential default. Sounds scary, right? Thankfully, this is a very-low-probability scenario.
If lawmakers do not iron out a deal in the coming weeks, you can bet on a spike in market volatility, but it’s important to remember that not all asset classes are created equal. History tells us to expect the following if no progress is made:
Equities: Expect a jump in volatility and a 10%-plus decline. Not all markets will suffer the same fate, as value stocks typically outperform growth and foreign generally outperforms U.S. during these periods.
Bonds: As ironic as this may sound, long-dated U.S. Treasuries would perform very well, along with U.S. corporate bonds. High-yield (junk) bonds would likely see a sizable decline. Investors tend to flock to high-quality, lower-credit-risk bonds in times of volatility.
Commodities: Gold and silver would likely rally, while oil prices would likely decline on recessionary concerns.
In most of these past situations, equity markets sold off in the months leading up to a debt ceiling showdown. In both 2011 and 2013, the S&P suffered declines leading up to the deadline but rallied 20%+ in both instances a mere 12 months later.
We have not experienced a decline this year due to the debt ceiling, which is not shocking as markets have been resilient in the face of countless issues. Some ask how this resilience is even possible. We believe it’s because markets have grown accustomed to some sort of last-minute deal to avoid the worst-case scenario.
Could this time be different? It’s possible. Might markets get jittery in the coming days and weeks? Absolutely. In our opinion, none of these concerns warrants drastic portfolio or risk changes, as such situations are out of our control and usually resolved rather quickly. Markets are fast-moving, and even if there is a shutdown, it likely will be short-lived.
Historically, markets have recovered quickly. While each shutdown presents its own challenges and obstacles, we’ve seen this movie before. The only thing we don’t know is the exact ending.
We’ve said it countless times, but diversification is your BEST FRIEND in times like this. No one wants to lose money, but not only does being diversified help provide a cushion, but some investments, specifically high-quality bonds, could see a significant increase in value.
To say we have been through this before is quite the understatement. Does it feel like there is more gridlock in Congress as both sides are seemingly unwilling to compromise? Sure, but I can promise you this won’t be the last time we have that feeling.
Every shutdown shares one common denominator, and that is markets achieved fresh all-time highs not too long after. Why? Because this is what markets do. Volatility is part of the process, and trying to avoid it is much harder and more stressful than it sounds.
While it can be challenging, try to focus on the bigger picture and not worry about short-term market swings.
Stay the course …
Discuss your situation with a fee-only financial advisor.