Investors have had no shortage of things to worry about in recent months, from economist predictions of recession, to banking stress fractures in the U.S., to a debt ceiling dilemma in Washington. Like always, there are issues that deserve the worry and some that may not be as bad as what people originally think. For advisors, we are on the front line in the battle against investor anxiety. In our daily fielding of questions and concerns, the one that has risen to the top of the heap is indeed the U.S. debt ceiling and whether we are on the precipice of an economic catastrophe or simply going through another round of Washington drama?

 

We have been here many times and that shouldn’t be a surprise. From a Canadian perspective, the way fiscal policy is conducted south of the border is unnecessarily convoluted. Each year there is a back and forth between the Administration and Congress over what the budget will look like. Ultimately, a budget is passed and that means that spending measures are approved for the coming year. Later that same year, if the level of federal government debt looks set to break through a self-imposed limit, we get into this debacle – even though the legislative branch of the US government has already passed the spending. Most rational people will acknowledge that fiscal policy has to be conducted with an eye to not creating excessive debt, but having an arbitrary debt ceiling that triggers too-frequent episodes of drama isn’t productive. That said, the need for a resolution on getting debt under control, even if there shouldn’t be a ceiling, is clear given that we are close to $30 trillion right now.

 

 

 

 

The drama stems not only from the fact that the ceiling is arbitrary, but because there is never a clean vote on increasing the limit. Like years ago, the vote gets smudged with other fiscal initiatives that lead to an immediate butting of heads. This confrontation can become more intense when we are a year away from a presidential election, like today.

 

At the time of writing, Speaker Kevin McCarthy had successfully moved his debt limit bill through the House of Representatives, defying some skeptics that he wouldn’t haven’t enough Republican votes to get it done. The margin of victory, if we can call it that, was two votes and it now sends the ball back to the White House for negotiation. The White House and Senate (controlled by Democrats) has already said that this bill is a non-starter because it includes spending cuts (outside of defense) that are simply not palatable. The White House has demanded that a debt limit bill contain no strings, yet that isn’t going to fly either, considering the projected trajectory for debt and interest costs.

 

How close is the US to breaking through its debt limit? In the coming days or weeks, we anticipate that the US Treasury will release an updated estimate of the date where the US will default on its debt payments. Previously, that was supposed to be in July, but economists have since looked at the delay in tax revenue receipts and figure it could come as early as early June. In other words, the date might be 4-5 weeks from now. That can be an eternity in a trader’s eyes or a flash in a politician’s, so let’s step back and look at what these next several weeks could offer up.

 

 

 

If the White House and Senate Democrats stick to their agenda, the ball will again pass back to McCarthy. He could stand his ground, or he might bend and send an amended bill that has no strings. Extreme right-wing Republicans won’t like that, and they could push for a vote to remove McCarthy as speaker (remember that he didn’t exactly skate easily into the position). This indeed is possible, but there are greater political laws of physics at play here than just who is the speaker of a fractured House, and that is where the election comes in.

 

While the 2024 vote can serve as a lightning rod for division and acrimonious behaviour, it can also provide an epitome moment. This past week, Joe Biden officially announced that he will be running for re-election. If successful, he will complete his second term at the age of 86. While there is certainly a path back to the White House, many in both parties believe that there might have been more formidable candidates in the Democrat ranks.

 

For Republicans, this has probably been seen as a positive development and some may believe that the election is now theirs to lose. True, there may be a candidate for the Republicans that emerges which tilts the balance back against them. When playing a game, however, that you think can only be lost by your next move, there usually is a reluctance to avoid mistakes. One such mistake might be sending the economy over the edge of the cliff because you (or your party teammates) voted in such a way to make the debt ceiling crisis a reality.

 

This game nuance is not limited to Republicans. If there is a sizable segment of the Democrat establishment that thinks a redux of 2020 might not produce the same result in 2024, then this is not a game where you are approaching it from a position of strength, but one where you are challenged. The net result is the same though, as you can’t afford to make an error – like sending the economy over the cliff. And for this reason, Ally and I believe this debt ceiling debate will not become a self-fulfilling prophecy, but more likely another 11^th hour decision by both sides of the isle to acquiesce. That doesn’t mean we won’t see jitters leading up to this decision.

 

 

 

 

As we have commented in our meetings, financial markets (the equity market in particular) have been acting a little too complacently of late. Yes, we agree that the banking tremours in the US are more transient than systemic and that the upcoming (current) downturn in the economy is not likely to be massive in scale, it’s just a little too calm if you ask me. Perfect conditions, in my opinion, for drawn-out debt ceiling negotiations could give some traders a reason to sell. This may also coincide with some other external factors, whether an economic development or something outside the US.

 

Again, if volatility experiences a near-term spike and equity valuations decline, it could provide an opportunity to deploy cash. This may also provide the Federal Reserve with enough tightening in financial conditions (on top of what we think will be their last quarter-point rate hike next week) to allow for a pause and shift to easing by the start of 2024. That will also be good news for the bond portfolio.

 

After this, you may be thinking that all is good. Just another debt ceiling hissy fit, rattling the nerves of day traders, followed by a sigh of relief. This indeed is possible, yet this is a very short-term focus. Even if a debt-ceiling bill is passed, what direction does the US take? Even now, the projected interest cost is one trillion dollars per year. Think of that number. Not too long ago, this was the gross domestic product of Canada. If interest rates magically fell back to zero in the coming year, this might not be a major problem, but without another economic shock like the pandemic, this isn’t going to happen. Most likely, rates are going to stay higher than their recent averages, at the same time that economic growth struggles to match the effective rate of interest on debt.

 

At some point we may revisit the 1990s, when the US and Canada were forced to confront their government debt problems with fiscal austerity that makes McCarthy’s bill look tame. Most of us remember what happened next. Social and health platforms were slashed, though without an actual recession being created, and deficits and debt came down.

 

In our opinion, investors need to be looking forward to the next 5-10 years in terms of how to properly structure their portfolios, rather than getting caught up in the high-frequency drama around the debt ceiling debates.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.