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Should you be worried about the debt ceiling crisis?
Analyzing the historical impact of the Debt Ceiling crisis on the stock market
Hello folks 👋,
First things first. There were some massive developments last week :). Graham Stephan made a video featuring various analyses I had done over the last 6 months. Thanks to his shout-out, we have added more than 400 subscribers last week, and we are this close (👌) to 7,000 members. If you haven’t joined the community, do consider subscribing!
Last week’s news was dominated by controversy around raising the U.S Debt Ceiling and ramifications of a default by the US Govt. While there is a lot of political grandstanding involved in what should be a regular process, in this week’s analysis, we are going to leave the politics aside and deep-dive into the debt limit, how it can affect the financial markets, and what happened last time the U.S almost defaulted?
What is the Debt Limit and why is it a cause of concern now?
The debt limit is the total amount of money the U.S Govt is allowed to borrow to meet its existing legal obligations (Social Security, Medicaid, interest on the national debt, etc.). You can think of it as the credit limit available to a country. The debt limit was created in the early 20th century so that the treasury did not have to ask permission each time for it to issue bonds (Again, exactly like a credit limit where the bank does not care what you use it for as long as it’s under your limit).
The cause for concern regarding this is that the current U.S national debt stands at $28.43 Trillion and the borrowing cap is set at $28.4 Trillion. Technically, the country has hit the debt limit last July and the Treasury has been using extraordinary measures  to delay the default. It’s estimated that the Treasury will run out of funds sometime between Oct 15th and Nov 4th , and will then default on its interest payments.
But it’s not like raising the debt ceiling is an extraordinarily rare event. It has been revised more than 5 times in the last decade and to quote the U.S Treasury:
Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit.
Historical analysis of the debt ceiling controversies
It’s not the first time the debt ceiling has come to the forefront of financial news and we can prepare for the next one by analyzing what happened during the previous debt crises.
I started off thinking I will have to pull all the data manually but Goldman Sachs has done all the heavy lifting with this report. Both Bloomberg and Goldman Sachs state that U.S government shutdowns have no meaningful impact on equity returns and the underlying economic conditions were more important to the stock market performance .
Charles Schwab also came to the same conclusion by analyzing the impact of the previous 18 government shutdowns on the S&P 500 and found that the median return over the course of a shutdown was 0.0% and the mean change was -0.6%.
If it doesn’t affect markets, why should I care?
While the government shutdowns don’t have any significant impact on the stock market, a prolonged fight over the debt ceiling can cause the U.S Govt to default on its interest payments. The only time the U.S was close to defaulting on public debt was in 2011 due to the delay in raising the debt ceiling. This resulted in Standard & Poor’s downgrading US Credit rating from AAA to AA+ .
The downgrade and the debt ceiling debacle caused Wall Street to have its worst day since the 2008 financial crisis with the major U.S Stock indexes sinking between 5% and 7%.
Black swan event of US Debt Default
The U.S Govt has never defaulted on its debt till now. But, even a short-term delay in paying off the interest obligations is bound to have a long-term impact on the economy. In the words of Treasury Secretary Janet Yellen,
It would be disastrous for the American economy, for global financial markets, and for millions of families and workers whose financial security would be jeopardized by delayed payments.
This is because a delayed payment would certainly affect the U.S Credit rating negatively and the international creditors who generally view the treasury debt as risk-free investments (because it is backed by the U.S Govt) would no longer see it that way. This would in turn make it more expensive for the federal govt to borrow money down the line.
Adding to this, a vast majority of players in the global financial system use U.S Dollar as the reserve currency. It is considered as the de facto global currency and is kept by many governments as a reserve. The dollar is strong only because of the U.S economy and the safety of the U.S dollar. A default by the U.S will shake investor confidence in the currency and is bound to cause a steep drop in exchange rates. This will drive significant capital outflows.
While no one exactly knows what would happen in the case of a prolonged default, Moody’s Analytics earlier this month predicted that
in a prolonged default scenario, the U.S. would slide into recession, with the Gross Domestic Product falling by almost 4%. Some six million jobs would be lost, driving the unemployment rate up to 9%. The resulting stock market sell-off would erase $15 trillion in household wealth.
I don’t think the U.S is going to substantially default on its public debts, a sentiment that is shared by other rating and financial agencies. This report from Brookings argues that the treasury would never let the Govt default on its debt payments and would most likely issue new debt and then use that to pay off the old one, all the while staying under the limit.
The last few times a similar issue came up, the congress was able to reach a compromise in the nick of time. But cutting the deal too close to the deadline might spook investors and force the rating agencies to downgrade the debt quality. Both of these, at least in the short term would adversely affect the market. While you should not be extremely concerned about a U.S debt default, it's a good idea to hedge your portfolio against the expected volatility by having a small amount of long-dated puts.
Until next week…
 The date is difficult to pinpoint due to the uncertainty regarding government spending as well as the tax revenue estimation.
 Although, they have noted that the performance of companies that gets more than 20% of their revenues from the Govt underperformed their respective benchmark during the previous debt ceiling crisis.
 This was widely criticized as a poor move on the part of Standard and Poor’s with them giving undue importance to how the politicians were squabbling over the debt ceiling over the actual financial status of the country. S&P’s then president Deven Sharma had to step down within 18 days of downgrading U.S credit.
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