By John Lau
May 17, 2023 – The high-level meetings between Republican leaders and President Biden have so far yielded no real progress on the debt ceiling, and with just two weeks until the “X” date (the date at which the Treasury hits the debt ceiling) many people are asking questions about what might happen if there’s no deal. Given that, I wanted to provide my view of 1) What a default might practically mean and 2) What it could do to various asset prices. Much of the basis of this analysis is based on the last debt ceiling drama in 2011.
What happens if there’s no debt ceiling deal? First, there is an important difference between hitting the debt ceiling and the U.S. defaulting. Practically speaking, the debt ceiling prevents the Treasury department from selling additional Treasury debt. That’s a problem, because regular sales of Treasuries are how the U.S. government funds its day-to-day operations. However, if the debt ceiling is hit and the Treasury department can no longer sell additional Treasuries, it does not mean the U.S. is bankrupt or in default. What it does mean, is that the Treasury department then has to “ration” its existing cash and decide who to pay, and who not to pay. So, the Treasury could choose to pay interest on existing Treasury debt, soldiers’ salaries, social security, and not pay federal workers’ salaries and federal contractors (this is just a theoretical example). The important point is this: Hitting the debt ceiling does not mean the U.S. automatically defaults on its debt (although headline news like to lump the two together). But it does mean Treasury would have to direct cash to essential services and payments and not pay “less essential” services. This matters because it would create a huge headwind for economic growth and make a hard landing more likely. First, the general uncertainty of the Treasury restricting payments would be a headwind on economic activity. Second, the delay of a paycheck from the Federal government to workers, contractors, etc., would cause an even bigger headwind on economic growth. This is the practical negative for the U.S. hitting the debt ceiling, and it would be more than just general uncertainty weighing on the economy.
What happens to asset prices if there’s no debt ceiling deal?
For this question, we have a blueprint for what to expect from this debt ceiling drama, because we had a very similar episode in 2011. Broadly speaking, here are the conclusions from the market performance during and after the 2011 debt ceiling drama:
First, longer-dated Treasuries performed very well, and longer-dated Treasuries were deemed a good place to “hide” during the debt ceiling drama. The 2011 debt ceiling drama really intensified in May 2011 (as is now), and the 10-year yield was around 3.2%[1] (current 10-year yield is 3.54%). By the time the U.S. got to the eve of hitting the ceiling (late July/early August) the 10-year yield had declined (meaning the 10-year Treasury had rallied). By the market bottom in late October 2011, the 10-year yield had dropped even further. And if we think about it, this makes sense because regardless of what happens in the next couple of weeks, no one seriously thinks that interest payments will not be made on 10-year Treasury debt, nor that this short-term Washington fiasco will materially degrade the credit worthiness of the U.S.
In my view, investors are looking at this event as a finite moment in time, almost like a pothole in the road. If we hit the pothole, it can cause some damage and discomfort, but it won’t derail the entire journey. And bond investors are avoiding this pothole by selling one-month Treasuries (the yield is currently over 5.58%[2]) and buying longer-dated debt, and I expect that to continue.
Second, history has shown us that stocks tend not to do well following debt ceiling dramas, even if it is resolved at the last minute. The S&P 500 fell 6% from May through August 2011 (when the debt ceiling drama really intensified) and dropped another 15% after a debt ceiling extension had been reached (source: Wall Street Journal). The peak-to-trough decline for the S&P 500 was more than 20% from May till October of 2011.
Third, defensive sectors handily outperformed in 2011. Utilities rose 19%, consumer staples gained 14% and healthcare rose 12%. The next best performing sector was consumer discretionary, which rose 5%, while financials and materials both dropped sharply, falling 17% and 11%, respectively. (Performance numbers from Yahoo! Finance)
Finally, gold rallied hard during the height of the 2011 debt ceiling drama, as GLD (SPDR Gold Trust) rose 20%[3] from early May through mid-August, although it gave back those gains over the remainder of the year. Bottom line, gold did prove a useful hedge against debt ceiling uncertainty and likely will again this time.
Bottom Line
The debt ceiling headlines will become more intense and scary in the coming days, but I wanted this analysis to provide independent, clear, and fact-based coverage of what we can expect from an “events” standpoint if the U.S. hits the debt ceiling (an event that remains unlikely, but not impossible).
At Robertson Stephens, our team in San Ramon and Burlingame will be monitoring the debt ceiling saga very closely. As our clients would know, we are already tilting defensive in my tactical asset allocation model; if the debt ceiling battle continues to drag on, we will be prepared to sector rotate to utilities, consumer staples, healthcare, and longer-term treasuries.
Our clients rely on us for timely information, and our job is to deliver.
Disclosures
Investment advisory services offered through Robertson Stephens Wealth Management, LLC (“Robertson Stephens”), an SEC-registered investment advisor. Registration does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. This material is for general informational purposes only and should not be construed as investment, tax or legal advice. Please consult with your Advisor prior to making any investment decisions. The information contained herein was compiled from sources believed to be reliable, but Robertson Stephens does not guarantee its accuracy or completeness. Investing entails risks, including possible loss of principal. Past performance does not guarantee future results. This material is an investment advisory publication intended for investment advisory clients and prospective clients only. Robertson Stephens only transacts business in states in which it is properly registered or is excluded or exempted from registration. A copy of Robertson Stephens’ current written disclosure brochure filed with the SEC which discusses, among other things, Robertson Stephens’ business practices, services and fees, is available through the SEC’s website at: www.adviserinfo.sec.gov. © 2023 Robertson Stephens Wealth Management, LLC. All rights reserved. Robertson Stephens is a registered trademark of Robertson Stephens Wealth Management, LLC in the United States and elsewhere.
Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Robertson Stephens Wealth Management, LLC and Fortune Financial Services, Inc. are separate entities and are not affiliated.
[1] YCharts
[2] Ibid
[3] Yahoo! Finance
What Happens If There’s No Debt Ceiling Deal?
By John Lau
May 17, 2023 – The high-level meetings between Republican leaders and President Biden have so far yielded no real progress on the debt ceiling, and with just two weeks until the “X” date (the date at which the Treasury hits the debt ceiling) many people are asking questions about what might happen if there’s no deal. Given that, I wanted to provide my view of 1) What a default might practically mean and 2) What it could do to various asset prices. Much of the basis of this analysis is based on the last debt ceiling drama in 2011.
What happens if there’s no debt ceiling deal? First, there is an important difference between hitting the debt ceiling and the U.S. defaulting. Practically speaking, the debt ceiling prevents the Treasury department from selling additional Treasury debt. That’s a problem, because regular sales of Treasuries are how the U.S. government funds its day-to-day operations. However, if the debt ceiling is hit and the Treasury department can no longer sell additional Treasuries, it does not mean the U.S. is bankrupt or in default. What it does mean, is that the Treasury department then has to “ration” its existing cash and decide who to pay, and who not to pay. So, the Treasury could choose to pay interest on existing Treasury debt, soldiers’ salaries, social security, and not pay federal workers’ salaries and federal contractors (this is just a theoretical example). The important point is this: Hitting the debt ceiling does not mean the U.S. automatically defaults on its debt (although headline news like to lump the two together). But it does mean Treasury would have to direct cash to essential services and payments and not pay “less essential” services. This matters because it would create a huge headwind for economic growth and make a hard landing more likely. First, the general uncertainty of the Treasury restricting payments would be a headwind on economic activity. Second, the delay of a paycheck from the Federal government to workers, contractors, etc., would cause an even bigger headwind on economic growth. This is the practical negative for the U.S. hitting the debt ceiling, and it would be more than just general uncertainty weighing on the economy.
What happens to asset prices if there’s no debt ceiling deal?
For this question, we have a blueprint for what to expect from this debt ceiling drama, because we had a very similar episode in 2011. Broadly speaking, here are the conclusions from the market performance during and after the 2011 debt ceiling drama:
First, longer-dated Treasuries performed very well, and longer-dated Treasuries were deemed a good place to “hide” during the debt ceiling drama. The 2011 debt ceiling drama really intensified in May 2011 (as is now), and the 10-year yield was around 3.2%[1] (current 10-year yield is 3.54%). By the time the U.S. got to the eve of hitting the ceiling (late July/early August) the 10-year yield had declined (meaning the 10-year Treasury had rallied). By the market bottom in late October 2011, the 10-year yield had dropped even further. And if we think about it, this makes sense because regardless of what happens in the next couple of weeks, no one seriously thinks that interest payments will not be made on 10-year Treasury debt, nor that this short-term Washington fiasco will materially degrade the credit worthiness of the U.S.
In my view, investors are looking at this event as a finite moment in time, almost like a pothole in the road. If we hit the pothole, it can cause some damage and discomfort, but it won’t derail the entire journey. And bond investors are avoiding this pothole by selling one-month Treasuries (the yield is currently over 5.58%[2]) and buying longer-dated debt, and I expect that to continue.
Second, history has shown us that stocks tend not to do well following debt ceiling dramas, even if it is resolved at the last minute. The S&P 500 fell 6% from May through August 2011 (when the debt ceiling drama really intensified) and dropped another 15% after a debt ceiling extension had been reached (source: Wall Street Journal). The peak-to-trough decline for the S&P 500 was more than 20% from May till October of 2011.
Third, defensive sectors handily outperformed in 2011. Utilities rose 19%, consumer staples gained 14% and healthcare rose 12%. The next best performing sector was consumer discretionary, which rose 5%, while financials and materials both dropped sharply, falling 17% and 11%, respectively. (Performance numbers from Yahoo! Finance)
Finally, gold rallied hard during the height of the 2011 debt ceiling drama, as GLD (SPDR Gold Trust) rose 20%[3] from early May through mid-August, although it gave back those gains over the remainder of the year. Bottom line, gold did prove a useful hedge against debt ceiling uncertainty and likely will again this time.
Bottom Line
The debt ceiling headlines will become more intense and scary in the coming days, but I wanted this analysis to provide independent, clear, and fact-based coverage of what we can expect from an “events” standpoint if the U.S. hits the debt ceiling (an event that remains unlikely, but not impossible).
At Robertson Stephens, our team in San Ramon and Burlingame will be monitoring the debt ceiling saga very closely. As our clients would know, we are already tilting defensive in my tactical asset allocation model; if the debt ceiling battle continues to drag on, we will be prepared to sector rotate to utilities, consumer staples, healthcare, and longer-term treasuries.
Our clients rely on us for timely information, and our job is to deliver.
Disclosures
Investment advisory services offered through Robertson Stephens Wealth Management, LLC (“Robertson Stephens”), an SEC-registered investment advisor. Registration does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. This material is for general informational purposes only and should not be construed as investment, tax or legal advice. Please consult with your Advisor prior to making any investment decisions. The information contained herein was compiled from sources believed to be reliable, but Robertson Stephens does not guarantee its accuracy or completeness. Investing entails risks, including possible loss of principal. Past performance does not guarantee future results. This material is an investment advisory publication intended for investment advisory clients and prospective clients only. Robertson Stephens only transacts business in states in which it is properly registered or is excluded or exempted from registration. A copy of Robertson Stephens’ current written disclosure brochure filed with the SEC which discusses, among other things, Robertson Stephens’ business practices, services and fees, is available through the SEC’s website at: www.adviserinfo.sec.gov. © 2023 Robertson Stephens Wealth Management, LLC. All rights reserved. Robertson Stephens is a registered trademark of Robertson Stephens Wealth Management, LLC in the United States and elsewhere.
Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Robertson Stephens Wealth Management, LLC and Fortune Financial Services, Inc. are separate entities and are not affiliated.
[1] YCharts
[2] Ibid
[3] Yahoo! Finance
Talk To Us