The United States reached the congressionally authorized debt ceiling on January 19th 2023. The Federal Government, which needs to borrow almost four billion dollars every day to meet its budgetary obligations, no longer has the authorization to borrow new funds through the issuance of U.S. Treasury securities. The raising of the debt ceiling is usually a formality. It has been increased 78 times since 1960, and was increased 17 times with little fanfare during Ronald Reagan’s Presidency. The last time the debt ceiling became a major issue was in 2011, during Barack Obama’s time in office. Present circumstances mirror 2011, with the House of Representatives controlled by the Republican Party and the Senate and White House held by the Democratic Party. This portends another nasty standoff over raising the debt ceiling.
Everyone knows that the impasse over the debt ceiling will be resolved eventually. The Federal Government currently runs a deficit of about 1.4 trillion dollars a year, and borrows to cover social security checks, Medicare payments to the U.S. medical system, as well as paychecks for millions of civilian and military personnel. There is broad political consensus to continue all these programs and payments. A failure to raise the debt ceiling could also lead to a default on U.S. debt, which would destabilize financial markets and economies worldwide. Given the stakes, it is surprising that the debt ceiling has become a political football again, but the showdown reflects the state of American politics.
The political reality is that neither party is likely to get much of anything they want passed in the next two years. The Democrats accomplished some of their legislative priorities last year when they had control of Congress and the White House. The Republicans lost a Senate seat in the 2022 elections, and won a bare majority in the House. They will be unable to pass anything of any consequence with the Senate and Biden blocking their path. About the only thing the Republican-controlled House can do is launch investigations and continue the search for Hunter Biden’s laptop. But some have bigger aspirations than that, and see the debt ceiling showdown as an opportunity to impress their constituents. The Democrats think raising the debt ceiling is an obligation of the government, and should be done without controversy, as was the case when Reagan, Bush, and Trump were in power. The Republicans see the debt ceiling as a lever, and the Democrats are in no mood to be leveraged by a party that barely controls one legislative body.
It is difficult to see how the standoff over the debt ceiling will end, even though it will at some point. Until that time, it is much like a game of chicken with two cars speeding at each other head-on with little inclination to veer away. Kevin McCarthy, who became the Republican speaker of the House by one vote after 14 failed attempts, will anger some extremists in his party if he even allows a vote on the debt ceiling without major concessions from Democrats. If he angers even a few members of his caucus, they will likely call for a new vote for Speaker and McCarthy will be voted out. The Democrats do not want to negotiate over the debt ceiling at all, and particularly not with someone seen as hostage to the extreme right. It may be that a collision is inevitable, and that a resolution will only come after economic damage has been done. The public should be prepared for months of posturing, as both parties try to pre-emptively pin the blame for any economic damage on each other.
Brinkmanship over the debt ceiling in 2011 contributed to a drop in the U.S. Dollar, a rise in precious metals, and a sizable decline in stock prices that took months to reverse. It did not lead to a drop in value for longer-term government bonds. While investors were concerned about receiving their money in a timely fashion on bonds coming due in the summer of 2011, at the height of the crisis, there was little concern that any default would extend to bonds coming due months or years from that date. We are not sure that history will repeat, but it could be a guide.
While the debt ceiling may become a major issue for investors by summer, it was rampant inflation that drove a historically bad year for investors in 2022. The S&P 500 declined by nearly 19%, while the technology-heavy Nasdaq Index collapsed by 33%. Investors fled riskier assets, with hundreds of high flying stocks favored during the pandemic losing 70% or more of their peak valuations. The most widely held cryptocurrencies plunged in value, and lesser-known crypto coins simply disappeared. The red-hot IPOs (initial public offerings) of 2021 turned ice-cold, with most selling for a small fraction of their previous highs. Yet the broadest financial pain was felt in a far more stolid investment: U.S. Treasury bonds. One index of medium-length government bonds declined by over 12% last year. For many who rely on the stability of bonds, this decline felt seismic. It amounted to the largest yearly decline in bonds across more than a century of reliable data.
Against that ugly backdrop, there has been some unequivocally good news in recent months. Inflation peaked in late summer and moderated through the fall and winter. With bond yields having reset to more normal historic levels and inflation no longer demanding such a draconian response from the Federal Reserve, bonds again seemed a stable and attractive investment option. We continued buying Treasury bonds for clients in the later months of the year, and captured the highest yields in 15 years.
Stocks have also begun to recover off the low set in October of last year. But stocks still have one very large hurdle to overcome before they can stage a full recovery. Much of the progress on inflation has come because of softening economic conditions. Weaker consumer spending has induced price reductions for various goods, and the housing market is beginning to cool in many parts of the country. While lower inflation caused by slower economic growth is good for bonds, it is not necessarily good for stocks. Slowing growth can compress margins, as firms find themselves overbuilt and overstaffed. Sliding into a recession is historically damaging for stock prices.
We see many signs that a recession may emerge in 2023, and have therefore been less inclined to assume that stocks have bottomed. In general stocks tend to reach bottom during a recession, not before one has started. Consumer spending declined over the last two months of the year and layoffs are spreading, particularly in the high-paying technology industry, but so far the economy is not in a recession. While there is debate about the likelihood of a recession, there is no doubt about the fragile state of the economy. Yet even after a year of declines, many stocks are not properly discounted for that fragility, in our view. That said, we remain alert to opportunities that may well emerge as the economic picture continues to develop.