The debt ceiling has been front and center in the news this year and we wanted to share our perspective on how we think of the debt ceiling with respect to client portfolios. Debt Ceiling Background and History First, it is helpful to understand what the debt ceiling is. The debt ceiling is the Congressional-approved limit of how much money the federal government can borrow to pay its obligations. The U.S. federal government reached the debt ceiling of $31.381 billion on January 19th, 2023. Since then, the U.S. Treasury has used what has been coined “extraordinary measures” to prevent default. On Monday, May 1st, Treasury Secretary Janet Yellen said that as early as June 1st, the government may not be able to pay its bills and could default on its current debt. The current debt ceiling issue is eerily similar to the 2011 debt ceiling crisis. At that time, there was a Republican-controlled House and a Democratic President. There was a large divide between the views of the political parties then, and the divide may be even larger now. In 2011, a last-minute deal was struck 2 days prior to default. During this time, financial markets responded negatively, and the credit rating of the U.S. Government debt received its first-ever downgrade by Standard & Poor’s from a AAA to a AA+ credit rating. Stocks declined more than 15% in a five-week period during July and August 2011. Paradoxically, many investors moved money to the perceived safety of U.S. Treasuries causing the yield on the 10-year bond to fall. This bolstered bond returns and the U.S. Aggregate Bond Index gained over 3% during this period. So how could the current situation affect your portfolio? It will really depend on what resolution to the issue is reached. However, during this time of uncertainty, we rely on our investment philosophy and the academic evidence behind it. We Believe in Efficient Markets First, we come back to the premise that stock and bond markets are fairly priced at any given time based on available information. Since the markets that we invest in are well-traded, prices reflect an equilibrium state between buyers and sellers. One individual might be selling an asset because they believe the market could deteriorate while another is buying because they think have the opposite view. Prices reflect these trades. Markets move upward and downward based on new information as it becomes available. Therefore, current market prices should reflect the possibility of a U.S. government default, as investors are aware of this risk. By making material changes portfolios, we would be implicitly betting that the markets are priced incorrectly regarding the issue of the U.S. debt ceiling. At this point, we don’t believe we have better information than that of the aggregate market. In addition, this is only one factor that is at play regarding market pricing. Earnings data, inflation data, recessionary risks, the Ukraine war, and many other data points are all factored into the market’s pricing of assets. Based on the efficient market theory alone, we believe the best course of action for most clients is to stay the course with their current investment and financial plans. What Are Your Personal Portfolio Needs? However, another way to look at the debt ceiling is with respect to your portfolio and your near-term need for funds. Will a potential short-term drop in portfolio value have a meaningful effect on your long-term retirement plan? On the opposite side, would missing a market rebound meaningfully hurt your long-term plan? In general, unless we can distinctly identify an immediate need for funds, we revert to markets being efficiently priced. Conclusion As a nation, we have never defaulted on our debt so it is very difficult to predict how the markets would react if this were to happen. There is no historical context to look back on to see the full ramifications of a U.S. default, but we expect it would have broad and severe repercussions. The effects go beyond just the stock and bond market as a vast segment of our country is dependent on government systems (Social Security, Medicare, SNAP, School Lunch Programs, etc.). This is why it is important for our government leaders to come to a compromise on the debt ceiling soon. In times of uncertainty, action tends to feel like a better course than inaction. It is important to remember that just because there are no immediate changes in portfolio recommendations due to the debt limit news, we have acted preemptively as part of our financial planning process. We have identified goals and created a lasting investment and financial plan, both of which are monitored and updated on a routine basis. In addition, these plans are stress tested for various market scenarios that could come. Although the allure of market timing is enticing, we believe investors will be better served in the long term by staying committed to their investment plan.
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