The U.S. debt ceiling debate has once again been making front-page news in 2023. While Congress and the President ultimately reached an agreement to raise the debt ceiling and allow the federal government to keep paying its bills, the level of political theater in Washington reached new heights, creating uncertainty about the economy and stock market. In the latest episode, media coverage of the finger pointing in Washington made the risk of a government default appear more likely than it really was.
This will not be the last contentious debate around raising the government’s borrowing limit. In fact, Congress has acted on the debt ceiling 78 times since 1960. However, rather than becoming wrapped up in the debt ceiling debate, we believe investors would be better off focusing their time and energy on other factors that are more impactful for long-term investing and financial planning.
To help demystify the debt ceiling debate, our chief investment officer, Brian Dorn, highlights what you need to know—and why your energy may be better spent on other issues.
What is the debt ceiling and why does it matter?
The debt ceiling is the maximum amount the U.S. Treasury can borrow. This limit was first imposed by Congress in 1917 and has been raised many times over the last century to its current limit of $31.4 trillion. Raising the debt ceiling allows the Treasury to borrow funds to pay for government obligations that have already been incurred through laws and budgets approved by the President and Congress. It is not a license to keep spending above what has already been authorized.
The ceiling is regularly raised because the U.S. government spends more than it takes in from taxes and other revenue sources. According to the Bipartisan Policy Center, the U.S. has run deficits of nearly $1 trillion per year since 2001, accumulating $25 trillion in debt over that period.[1]
The debt ceiling matters because it prohibits spending beyond what has been appropriated. But it is often used as an excuse for Democrats and Republicans to blame each other for mismanagement of the country’s finances. These acrimonious debates obscure the more serious problem of surging government deficits. Given how reticent politicians on both sides of the aisle have been to cut government spending, we believe the only way to resolve the national debt burden is through many years of above-average economic growth. In fact, the longest period without a rise in the debt ceiling occurred in the eight years after World War II when a drop in military outlays led to years of government surpluses.
What would happen if the U.S. were to default on its debt?
First, it is important to know that the U.S. government has never defaulted on its debt. But if it were to happen, the federal government would be forced to delay paying bills and, in an extreme case, cease interest payments to holders of Treasury bonds. Interest rates would likely rise as the country’s creditworthiness would suffer downgrades similar to the way corporate bonds do when markets question a company’s ability to make timely payments. A default may cause an economic recession as companies and individuals hoard cash and limit spending. Even worse, as the U.S. dollar is the world’s default currency and the U.S. its largest and arguably most important economy, the global economy could also spiral into a widespread recession.
A debt default could also have geopolitical ramifications due to the large foreign ownership of U.S. government bonds. At the end of 2022, foreign countries, companies, and individuals held over 23% of U.S. debt, led by Japan and China.[2]
Excluding an actual default, how else does the debt ceiling debate affect the market, economy, and investors?
In the short term, the veiled threat of not raising the debt ceiling causes uncertainty among market participants and increases volatility. If there is one thing market participants do not like, it is uncertainty.
A growing national debt burden and contentious debt ceiling debate in 2011 caused rating agency Standard & Poor’s to downgrade the U.S. credit rating from AAA to AA. This move unleashed a short-lived panic but, as has been the case throughout modern history, the economy and markets quickly recovered.
This is an important point to consider. The debt ceiling is just one of many distractions that can tempt investors to abandon their financial plan and play the fool’s game of trying to time the market. Investment professionals like to say that a key to successful investing is separating the signal from the noise. This means you should ignore the media’s short-sighted coverage of the financial markets and the economy and instead stay the course that you and your advisor have thoughtfully mapped out.
What should investors focus on?
As investors, we believe we should try to control what we are able to control. When examining the debt ceiling debate, we can control our risk levels and remain focused on the long term while understanding that this debate has happened before and will very likely happen again.
It is worth nothing that despite all the attention around the latest debt ceiling debate, financial markets were barely affected in May. Equity markets have been unusually calm for the last several months, owing to better-than-expected corporate earnings and progress in bringing down inflation. These are two areas where investors’ attention would be better spent: earnings and economic policy. (See our recent article on the Fed and interest rates for an update on economic policy.)
Earnings are probably the best gauge of stock market health. Every publicly traded company is seeking to make enough profit to stay in business. At Leelyn Smith, we target companies with established business models and wide competitive moats that contribute to consistent, growing profits over time. These companies have sturdy balance sheets with abundant cash to endure heightened market volatility, a recession, or even a government debt default.
They may not generate the excitement the media craves, but high-quality companies form the foundation of the proven investment strategies that allow you to build and protect your wealth over the long term. We concentrate on employing these strategies in an optimal manner rather than reacting to noise caused by events like the debt ceiling drama.
What’s ahead for the debt ceiling?
Legislation passed by Congress and signed by the President in early June suspends the debt ceiling debate until January 2025, removing it as a potential issue in the 2024 election. The legislation caps non-defense spending, rescinds some unobligated Covid-19 relief funds, cuts IRS funding, and restarts student loan repayments that were paused during the pandemic. This is a welcome development that instills a measure of fiscal discipline and gives investors one less distraction to worry about.
If you still have questions about the debt ceiling or how government spending may affect your specific situation, please don’t hesitate to contact your Leelyn Smith advisor.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
[1] https://bipartisanpolicy.org/report/deficit-tracker/
[2] Statista.com based on data from the Treasury Bulletin June 2023.