Debt Ceiling Debate Adds More Turbulence for Investors

Stipp: I'm Jason Stipp from Morningstar.

As if headlines don't have investors scared enough about falling off a fiscal cliff, this week saw a resurgence of concerns about crashing into the debt ceiling.

Here to talk about how the debt ceiling fits into this game of chess is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for joining me.

Glaser: Good to be here, Jason.

Stipp: You've been keeping us updated about the fiscal cliff. Can you first talk about any movement we saw on the fiscal cliff this week, and then what's going on with the debt ceiling now? This has come into the headlines?

Glaser: We didn't get a ton of movement in terms of the negotiations between the two sides about what the resolution that the fiscal cliff is going to look like. We just heard really more of the same. The president wants to raise taxes more than the Republicans want, wants to cut spending less. The Republicans want sharper cuts to entitlements, are willing to raise revenues, but want to do so without raising tax rates and are looking to raise a little bit less money. So that really stayed the same.

But there was a resurgence and talk about the debt ceiling this week. The debt ceiling is the statutory limit of the amount of money the Treasury is allowed to borrow. So essentially it says you could only issue X number of bonds. So it's not necessarily approving new spending, but it's approving the bonds that we need to issue to pay for this spending that we've already authorized.

We heard a lot about the debt ceiling in 2011. You remember there was a big fight over potentially raising the debt ceiling; it resulted in the downgrade of the United States sovereign credit rating by S&P, and certainly it was a big part of the story of the volatility that we saw in the summer of 2011. And I think we're starting to see the inkling of that volatility might be returning as the debt ceiling has become a pretty big bargaining chip as they try to figure out the fiscal cliff as well.

Stipp: So, why is the debt ceiling coming up? What's the connection between the debt ceiling and the fiscal cliff?

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Glaser: The debt ceiling is pretty important. The fiscal cliff you could probably say, look, we could just do nothing. And we've heard this from a few different places that maybe it's just better to let these tax cuts expire, to cut all of this spending. We're going to need to take our medicine eventually in terms of getting back to some sort of fiscal sanity again. And by doing this, it's going to be painfully in the short term, but it will help in the long term, and we won't have to keep having these fights.

But doing nothing isn't really an option because of the debt ceiling. We'll probably hit it maybe early next year, first quarter of 2013, maybe extra tax revenues from letting the fiscal cliff expire will push that out a little bit, but sometime in 2013 Congress is going to have to vote to raise the statutory limit. And because they have to act, it means that you can't just let nothing happen.

In order for that, you're going to have to have these negotiations, deal with a lot of the same issues that we have to for the fiscal cliff. So, it really means that these are issues that have to be tackled. It's not just something that we can wait for the automatic increases to happen. Because it has to be tackled, it just makes it that much more difficult.

Stipp: So, if they don't do anything or they can't reach an agreement on this debt ceiling issue, what would some of the consequences be?

Glaser: Well, I think we saw the beginning of those consequences last year. First off, it really could mean a partial or a pretty substantial government shutdown if the debt ceiling is breached. If you can't issue more bonds, you can't spend more money. You're going to have to cut that spending from somewhere. It's not clear exactly where those spending cuts would come from, exactly what part the government would shut down. Presumably this is something the Treasury has a contingency plan to do, but that's going to have a big effect on economic growth. You're just going to see … the government spending part of GDP really begin to shrink, and that's not going to look good for the rest of the economy, and also it's going to raise concerns about Treasuries as a safe-haven asset.

We saw that with the downgrade in 2011. I think we could see more potential downgrades. We could see people potentially thinking about Treasuries in a different way. It's hard to say if rates all of a sudden would spike. We saw in 2011 rates actually came down because there really aren't that many other options as safe havens. But definitely it raises some questions over the long term about the stability of Treasury bonds, and I think that that would not be a road that many people would want to go down.

Stipp: So the issues with the fiscal cliff, the points of disagreement happen to be around whether we would raise taxes on the higher income earners or not. With the debt ceiling, what's the main area of contention? Is it just that Democrats want to raise the debt ceiling and Republicans don't? Is it as simple as that?

Glaser: I think it's a little bit more complex, because the debt ceiling really is seen as a bargaining chip, I think, on both sides. And I think that's why it's getting so much play, not so much that there is just a simple disagreement about we should do it or we shouldn't do it.

On the Democrat side, the president really wants to take it off the table, is the term that he is using. He is saying, look, it doesn't make sense for us to have this fight all the time. It's counterproductive. We've already authorized the spending. He wants to move to a model where basically a supermajority of Congress would be needed to override his veto in order to keep the debt ceiling from not being raised. He thinks that means it will be smoother. They don't basically have to worry about it anymore, and certainly you could see why that's appealing to him, because it takes away the threat of going through the debt ceiling off the table, and maybe it makes doing nothing a possible solution and maybe strengthens his hand a little bit.

Republicans, on the other hand, really see this as the spur that they can use to try to get a better deal and get a deal that's closer to what they want out of the fiscal cliff negotiations. They can say, look, we'll give a little bit on rates now, but once this debt ceiling debate comes up, if they don't raise it in this first part of the fiscal cliff negotiations, they think that they can use that as leverage for more entitlement reforms. They can leverage it to keep rates lower or to lower rates even if they agree to raise them later this year.

So, I think that they just don't want to take this off the table all of a sudden or make it difficult to use it as a bargaining chip. I think because of that and because of how important it is to actually raise it, I think it's going to be very difficult to convince Republicans to take it off the table. It's going to be a big part of the negotiations.

Stipp: If they can't reach a deal, are there any other safety valves or mechanisms that we could get around this debt ceiling, at least in the short-term?

Glaser: There has been some talk about the so-called "constitutional option." The 14th amendment of the Constitution has some language about the United States debt shouldn't be questioned. This is after the Civil War, and they just wanted to make sure that everyone knew that the Union's debt would be repaid. It's not really clear exactly what that means. There certainly have been some people, Bill Clinton for example, saying that he thinks that the president would have the authority to keep issuing debt even if the debt ceiling wasn't raised.

President Obama thinks differently. He issued a statement this week through his press secretary that they just don't think that this is a real option. Their lawyers have looked at it. They just don't think it's reasonable. I think if you imagine issuing these bonds that weren't approved by Congress, but that were being issued anyways, I think it would cause some, I don't want to say havoc in the bond market, but I think they would probably have to pay a higher rate on them. You'd have this class of bonds that maybe would be treated differently than other bonds that the U.S. has issued. I think it would be an incredibly messy solution. I don't think it's one that people should count on. Certainly there might be some chance of it happening, but given the president's statement so far, it just doesn't seem very likely.

Stipp: So, we have a fiscal cliff, we have the debt ceiling, we have a lot of continuing wrangling in Congress right now. As an investor, what does this mean, especially this injection now of the debt ceiling. We knew it was going to happen, but it's starting to heat up again.

Glaser: It's challenging. I think we can look back again to 2011 as a template for some of the consequences. We saw a big slowdown in investment spending and people basically saying, until we know how this is going to be resolved, we're just going to sit on the sidelines and we're not going to make any big moves until we know that the United States' debt ceiling isn't going to be collapse and that we're not going to have these big issues. I think we're going to see that again.

So far in the data, we haven't seen a huge pullback--certainly superstorm Sandy has had made the data a little bit more difficult to read. But I think in December as we hear more and more about the fiscal cliff, as it becomes more apparent that the debt ceiling could be a problem, as it becomes more apparent that the two sides may not come together, I think you're going to see businesses pull back a lot in the face of the uncertainty. That's not going to do great things for economic growth. It's not going to do great things for employment, and it could be a while until the fiscal cliff gets resolved, and these fiscal issues get resolved, that businesses will be back investing and have the confidence to do that. So, even if we make this fiscal cliff agreement eventually, or we get through this debt ceiling agreement eventually--which we still think is the most likely outcome--it has real consequences today as businesses pull back ahead of it.

So, I think for investors, there could be more volatility ahead, and we just go back to our old adage of holding an asset allocation that makes sense for you, making sure you're in high-quality names on the stock side, that you're ready to ride out that volatility. I think that for investors, it could certainly be a bumpy ride.

Stipp: Alot of moving parts on the policy front, Jeremy, but thanks for helping us to keep track of the details.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.