The most pressing concern for the economy has recently transitioned from inflation and bank failures to a new topic — the drama du jour is the debt ceiling.  As the deadline for extending the debt ceiling rapidly approaches, the consequences of not raising the restriction could be catastrophic for the global financial system. The Rolling Stones tune “Play with Fire” is the perfect title to express the current situation and serves as a warning to politicians to stop the madness and work together to find a solution. 

A Country Divided

The 118th U.S. Congress reflects the extreme division of our country today. Not only are the two political parties divided, but there is division inside each party as the extremes keep moving further away from the middle. The result is an inability of Republicans and Democrats to work together to solve our nation’s problems.

"Well you've got your diamonds

And you've got your pretty clothes

And the chauffeur drives your car

You let everybody know"

Political divisions have become political theatrics, and like the girl in the Stones’ “Play With Fire,” most of the players seem happy to let everybody know about their “diamonds” of division, diamonds that have ultimately halted decision-making. And while indecision has historically been a positive for the stock market because it keeps the government out of the way, indecision is a liability in this unique case.

History of the Debt Ceiling

The debt ceiling is a statutory limit on the amount the government can borrow. It was enacted in 1917 by Congress during World War I to allow the U.S. Treasury to issue bonds (debt) without congressional approval as long as long as it remained under the debt ceiling.   

Congressional approval is required to raise the debt limit. The proceeds from the debt are used to fund government operations not covered by tax collections. Issuing more debt is often how the country pays its current debt, which is like taking out a new credit card to pay an old credit card’s interest. Further, the funds are used to pay for Social Security and defense spending.

Since 1960, the debt ceiling has been raised 78 times under both Republican and Democratic administrations.  The U.S. has NEVER defaulted on its debt obligations. 

In 2011, the debt ceiling debate was akin to the current situation we find ourselves in today.  One party wants to extend the debt ceiling, the other wants spending cuts (or something in exchange for agreeing to extending the debt ceiling). The parties “play with fire” in an ugly display of political posturing and horse-trading with the country’s financial stability as the hostage. 

At the last minute in 2011, a deal was struck, and the debt ceiling was extended until 2013; however, there was damage done along the way. In August of 2011, the debt of the U.S. government was downgraded for the first time ever. The S&P 500 declined 19% from the peak in 2011 before a rally back into year-end left the market almost unchanged for the year. The chart below displays the ride of the S&P 500 in the last debt ceiling debate to serve as an example of how stocks may react this time around.  (Source Bloomberg)

The Current Situation

Treasury Secretary Yellen recently stated the country will be over the current debt ceiling limit of $31.5 trillion by June 1. This means the country cannot pay the debt holders.

"But don't play with me

'Cause you're playing with fire"

On May 9, President Biden met with congressional leadership to begin the debt ceiling discussions.  There was no sign of compromise, both sides continuing to play with fire, but the meeting itself was progress and an important first step. During the follow-up meeting on May 16, both sides agreed defaulting on the debt isn’t an option, but still neglected to reach a deal.       

How to position a portfolio?

Given the great divide in the country, we believe the debt ceiling process could result in declines in the stock market over the next month. We believe the debt ceiling will get extended, but that the deal will be struck at the last minute after much drama.

We advise holding some “dry powder” to be ready to buy stocks on a dip. As the stock market declines, we will be purchasing stocks or bonds driven down, but not fundamentally affected by the negotiation process. In other words, there will be a nice buying opportunity created for select stocks. 

The Conclusion

We all know the U.S. will not default on credit obligations, right? However, history teaches us that the stock markets do not like the uncertainty or the drama created as a part of the process. The close call on default does not send a strong signal to the country’s debt holders.  

Prepare for volatility, scary headlines, and threats by politicians looking to stoke the fire. The team at Lear remains poised to take advantage of the declines and opportunities created.  Taking the largest economy in the world and its debt holders’ hostage for political gain is just the sausage-making part of politics.  It will pass and there will be a solution. 

This is the greatest country in the world, and we believe common sense and the good of the people will prevail.