Fri, 18 Jan 2013
Although we're unlikely to face a worst-case scenario on the debt ceiling debate, it's important for investors to understand the potential consequences.
Update: On Friday, House Republicans said they were planning on passing a debt-ceiling extension next week that would buy the Treasury Department another three months. This move isn't shocking, as we expected that the high costs of default would mean that the ceiling would be raised. But this doesn't mean that the uncertainty around the United States' fiscal issues is gone. We have two more near-term battles regarding the planned sequestration cuts and the budget resolution that need to be passed by the end of March to avoid a partial government shutdown. And if these are not resolved satisfactorily, we could very well be talking about the debt ceiling again in three months.
On the whole, this move underscores our thesis that we are unlikely to breach the debt ceiling but that debates over other fiscal issues will continue to add another layer of uncertainty to the market. --Jeremy Glaser
Jason Stipp: I'm Jason Stipp for Morningstar.
So you survived the fiscal cliff round one. There are two more words, though, that you're going to be sick of hearing in the next few weeks: "debt ceiling."
Here to talk about exactly what the debt ceiling is and what are the implications for the government and potentially for investors is Morningstar markets editor Jeremy Glaser.
Jeremy, thanks for joining me.
Jeremy Glaser: Jason, my pleasure.
Stipp: So, before we talk about some of the different possibilities here, first of all, what is the debt ceiling exactly? What does it mean and what would bursting through the debt ceiling mean?
Glaser: The debt ceiling is the statutory limit for how much debt the Treasury can issue. Congress passed a law that says, as the United States Treasury, you can only issue "X" trillions dollars of debt, and if they reach that limit, they can no longer sell bonds in order to fund the spending that Congress has also authorized. It puts us in quite a bit of a conundrum, because on one hand Congress says you have to spend this money, but on the other hand they tell Treasury that you can't actually sell bonds to do it. We get to this impasse where you have a lot of very unpleasant choices to make.
Stipp: So, this is spending that has already been authorized, but now they have to essentially authorize the payment of that, and that is now what we are coming up against--the debt ceiling. We've had a lot of rancor over the debt ceiling in 2011; they managed to get through it at that time, but it has come up again where they have to raise it one more time. What are the negotiations looking like now?
Glaser: You're right that this is not the first time that we've been arguing about the debt ceiling. It's something that has come up time and time again, especially in recent history. And right now, this negotiation is happening fairly quietly.
Officially, both sides are still very far apart. The administration is saying that they only want a clean debt ceiling vote; they want Congress just to approve an extension. While Congress, and particularly the House Representatives, are saying that they want spending cuts attached to that debt ceiling increase, and they see this as leverage in order for them to get some of those cuts through.
But we've heard a little bit of softening of rhetoric recently, particularly amongst Republicans who say, well, if we don't use this as leverage, maybe there are some other opportunities coming up--maybe in the continuing budget resolution to fund the government for the rest of the year that comes up at the end of March, or with the sequestration cuts, and it's not worth playing with the fire of the debt ceiling.
That kind of talk to me signals that, just like the fiscal cliff, it's likely that a lot of these issues will be dealt with at some point. It might be with a minority of the Republican caucus voting with the Democrats again in the House. It might come from a couple of different [scenarios], but it seems much more likely than not that the debt ceiling will be raised, but I still think it's important for investors to understand the consequences if it's not, and perhaps prepare for it.
Stipp: So, Jeremy, I have actually read that we already went through debt ceiling, but Treasury is able to do some twists and turns and some maneuvers to still pay the bills. What's going on with that and what happens when Treasury can't do those twists and turns and moves anymore, and the bills can't get paid?
Glaser: There are some extraordinary measures that Treasury can do, and has been doing since the end of December--they did it in 2011--where they can raid different parts of government funds essentially in order to keep things going.
So, for example, in the Thrift Savings Plan, which is kind of like a 401(k) for government employees, there is a stable value fund. Treasury is allowed to go in there and take some of that out temporarily in order to fund the government, as long as they put it back after the crisis is over. So they have started doing that. But that's not going to go on forever.
The Bipartisan Policy Center believes that sometime between Feb. 15 and March 1, they are going to run out of options, and they're going to be faced with the fact that they have less money on hand than money that needs to go out the door. We just don't know exactly how Treasury is going to handle this.
The administration has been very tightlipped about what would actually happen if we go through the debt ceiling. And part of that is a negotiating tactic--if they make it seem that there is a reasonable way to get through the debt ceiling without having major economic consequences, … then perhaps that would embolden [legislators] to say, well, we're really going to use this; we're really going to be able to push this right to the limit. So they've been silent there, and have batted down ideas like the trillion dollar platinum coin that some people talked about as a way to get around this crisis.
We do have a little bit of a hint. In 2012, the Treasury released a report about the 2011 crisis, and some of the things they were considering and why or why not they would think it would work.
The first were asset sales--going out and selling gold from Fort Knox. They thought that fire sales into the market would just not raise enough money to really make a difference and could potentially lose the taxpayers a lot of money because they wouldn't get the full value for these assets. So, they dismissed that.
The second idea was that maybe they will just cut everyone's checks, say, in half or by 40%, so you will just get less than you should, but that you would get the rest of your money later when the crisis had passed. Now, the problem with that is the Treasury's computer systems actually can't handle those kind of transactions, which doesn't seem like a wonderful excuse, but if you think about the number of bills that Treasury has to pay, it's not something they could program overnight, and it's something that they say they haven't worked on and aren't working on. So that option is probably off the table.
The third is prioritization, which is something that we hear a lot about, which is the idea that [Treasury] will only pay some of the bills, and we'll leave other things unpaid. So, therefore, we could continue to pay Social Security, continue to pay for defense spending that is necessary, but not fund parts of the government that maybe could go a few weeks without operating. There are a couple of problems with this. The first is that the Bipartisan Policy Center says that [the money coming in would cover] about 60% [of the government's obligations] … and 40% would be a deficit. So, we'd have to find 40% of the government that we weren't going to fund for a while, and Making those choices is challenging. Treasury says that they don't believe they have the legal authority to make those choices. That when Congress appropriated this spending, they didn't say this spending is more important than this spending; it's all on equal footing. And they feel uncomfortable saying, this program is important, this program isn't important. People are going to disagree about that. What's important to me might not be important to you. They are worried about some of the politics and the optics of that. That's one concern they have. Another concern, again, is with the computer systems. They don't think it's actually possible to stop the payment for 40% of the government. Maybe you could get those institutions not to submit their bills, or you can find some way around it, but … they are not terribly convinced that's actually a sound strategy. That's one of the biggest problems with prioritization.
So, they came to the fourth idea, which is the one that they had settled on as the least-bad choice, which is delay. So, you have to pay an entire day's worth of bills in full, and you just wait until you have that money in the bank before you send it out. So, that would mean that, at first, you would see things maybe delayed by a day or two, and then it would snowball, that as the debt ceiling continued to not be raised, we'd see payments get later and later and later.
Now in this scenario, there is a chance there would be a way to prioritize a very small section of bond interest and principal payments, so that those would get paid on time. That's not 100% clear to me, but that potentially is a possibility.
So, it seems like [delaying payments] is what would happen if we do hit the debt ceiling and if we do go past these extraordinary measures. But it's important to note that none of these scenarios are good, that even the least-bad scenario would probably still be viewed as a default on U.S. obligations--that 40% that we're not paying--and could have some serious economic consequences.
Stipp: So I know what it means if an individual defaults. I know what it means if a business defaults. What would it mean if the U.S. technically defaults because they had to resort to one of these options here?
Glaser: The truth is, we don't know. We can look back to that 2011 debt ceiling debate to see how the market reacted. We got very close, and after S&P downgraded the U.S., Treasury yields actually fell instead of rose. People didn't see that there was more credit risk. They were looking for safe havens, and they still saw Treasuries as that safe haven. Part of that is that the expectation was that even if we have these mild disagreements, they would be short-lived and that the full faith and credit of the U.S. was still behind these bonds.
But I think also, there aren't a lot of other safe assets to go to. Certainly there are some smaller countries that have very sterling balance sheets, but their markets aren't large enough to support that kind of debt [similar to the amount of U.S. Treasury debt]. A country with a great balance sheet doesn't have a lot of debt anyway, by definition. So you don't have a lot of places for this money to go. People looking for safe havens, getting out of equities and getting out of corporate bonds need to go somewhere, and they went to Treasuries.
So, it seems that it's possible that even if we did default, we wouldn't see a huge spike in Treasury yields in the short term; maybe over the long term the market would re-assess, would be able to adjust more, and we would see higher long-term rates, which would mean … more borrowing to pay that higher interest, and it could mean higher rates for consumers. That would be more of a long-term concern.
In the short term, the spending cuts are what could really hit the economy, and the lack of confidence could really hit the economy very quickly. We talk about sequestration a lot, which is $100 billion of cuts that would be spread out over 12 months and how that could potentially help push the economy into a mild recession. Well, the Bipartisan Policy Center thinks that over the month, from Feb. 15 to March 15, there would be about a $175 billion deficit. So that's more than sequestration, and it would happen in a month, instead of over 12 months.
So that's a very big cut to government spending happening very quickly, which could have an impact on growth, and it could pull us into a recession, let alone the impact on consumer confidence, on business confidence, on investment--all of those things that we worry about when we have a credit crisis or we have a crisis like this.
Stipp: So, Jeremy, this debt ceiling, as an investor, is putting me in a really tough spot, because not only do I have uncertainty about whether they will resolve it and be able to raise it, but there's also uncertainty if they don't, what potentially could happen and to what kinds of assets. So, what should I be thinking about as an investor, given that I just don't know?
Glaser: The first thing I'd reiterate is that it's not terribly likely that we're going to have this worst-case scenario with the debt ceiling. It sounds like both sides, like I was talking about earlier, are softening their positions a little bit. They might move this battle to either the sequestration cuts or to the continuing resolution, and not resolving [those issues] would not have as dire an impact as some of these debt ceiling issues. So we're going to hear a lot about the debt ceiling, but also keep an eye on those as well as an investor.
I think it shows the importance of having an appropriate asset allocation for where you are in life and what you want to get out of your portfolio. In your short-term bucket, for the money that you really need to live on, it isn't appropriate to have that in equities or in some fixed-income securities that could see a ton of volatility. Having it in a safer, more liquid asset class gives you the ability to take out that money to live without having to worry about selling into a falling market. That's something that's really important.
On the equity side, again, [we're] looking at these time-tested wide-moat companies as being good choices right now. They have the ability to fend off competitors. They have strong balance sheets generally. They're going to be less buffered by these economic winds. They might still fall and they might still see some of that volatility, but hopefully by less than the broader market. And then when you look out over 10 years, 20 years, 30 years, or whatever your horizon is for equities, they should be able to rebuild and get past some of this short-term pain without really hurting their earnings power over time. So I think those stocks would make a lot of sense for investors.
So, there's going to be a lot of noise. Trying to drown all of that out and stick to your long-term plan can be challenging, but I think it's the best way to play this potential issue.
Stipp: Jeremy, some sound advice for a potentially thorny issue, one that's certain to make the markets upset at some point or another. Thanks for joining us and for those insights today.
Glaser: Thanks, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.