US debt ceiling – what is it and should investors worry?

For the first time in a while, it’s not inflation and interest rates that are dominating market moves. That’s good news, right?

Not really. The trouble is that US policy makers have reached a stalemate over how much the US government can borrow. And, while the issue has been brewing for some months, the lack of progress has started to rattle investors now the deadline is approaching.

What is the US debt ceiling?

The US debt ceiling is basically a cap on the amount of money the US government can borrow to pay its bills.

Every few years the US debt rises and comes close to breaching the US debt ceiling, at which point it needs to be raised. Sometimes the decision to raise the ceiling is a routine one, but when you have a divided government as there is today, with the Senate controlled by the Democrats and the House of Representatives controlled by the Republicans, it’s not so straight forward.

“The Republicans are angry with what they see as excessive spending by the government and Democrats in the period following Covid,” commented James Yardley, senior research analyst at FundCalibre. “They want to see spending cuts, which is the opposite of what many Democrats want.

“Given the huge difference and animosity between the two sides getting a deal to raise the debt ceiling could prove difficult. Many Republicans believe they were elected on a mandate of reigning in spending. Both sides have to be seen to be tough which means these things tend to go down to the wire.”

What happens if an agreement isn’t reached?

If the US government can’t reach an agreement in time, the US could default on its debt. This would mean that it couldn’t pay federal salaries, military pension payments or its creditors (the people holdings its bonds) and parts of the government may shut down.

As US government bonds are seen to be one of the safest investments in the world, it could have a huge impact on investors.

“The last time this almost happened was in 2011,” explained James. “Equity markets fell quite significantly by about 19% from peak to trough. This time the animosity between the sides is even greater.”

“This could be the worst standoff we’ve ever witnessed,” agreed Capital Group political economist Matt Miller. “It certainly has the potential to be at least as bad as 2011.”

In 2011, Standard & Poor’s cut the United States’ prized AAA credit rating to AA-plus (where it remains) amid concerns about the government’s budget deficit, a growing long-term debt burden and political conflicts over raising the debt limit. “The move unnerved US financial markets for a time, but they quickly recovered,” said Capital Group.

What if the US defaults on its debt?

“We don’t really know what the downstream implications would be,” said Tom Hollenberg, a fixed income manager at Capital Group. “For example, there are banks whose ratings are somewhat linked to US sovereign ratings. There are insurance companies in the same situation, as well as agencies like Fannie and Freddie. It’s difficult to know what would happen to them if one or more of the rating agencies were to downgrade the US again.

“We could wind up with cascading downgrades, and that would be a real problem for some financial institutions,” he warns. “It’s not something we can just gloss over, and it’s why we need a timely resolution. I do think we will get one, I just hope it comes before we encounter any unintended consequences.”

From the point of view of an equity investor, the US debt ceiling debate makes for interesting political theatre, but it’s not something that weighs too heavily on investment decisions, says Steve Watson, co-manager of the Capital Group New Perspective fund.

“At the same time, I don’t think it’s necessarily a bad idea to have an occasional reminder that the United States is more than $30 trillion in debt,” he notes. “Maybe it’s time to engage in a serious discussion about long-term fiscal responsibility.”

“A default on US bonds is unthinkable and would likely lead to financial Armageddon across the world given the safest asset in the world is deemed to be US government bonds. This almost certainly won’t happen,” continued James Yardley.

“Some US citizens might not receive cheques, but the US is not stupid, and they will not allow a default or a missed payment of interest of principal. The US President would also likely invoke the 14th amendment to raise the debt ceiling and prevent a default.

“Ultimately we expect to get this to get resolved and any sell off in bond or stock markets will likely be an opportunity.”

Fund ideas if there is a market sell-off

Baillie Gifford American

“This is a high beta fund – it’s a riskier option. But if you use any sell off as an opportunity to invest, this fund could have the potential to generate much higher returns in the subsequent recovery,” said James.

Premier Miton US Opportunities

According to James, this US equity fund has exposure to the domestic economy and an overweight to mid-caps  – so is another recovery play.

JPMorgan US Equity Income

“This is a solid US equity fund, with the benefit of dividend payment, which tends to fall less than markets when they tank,” said James.

M&G Global Macro Bond

This is a  ‘go anywhere’ macro bond fund “which can take advantage of big moves in the bond markets,” according to James.

Allianz Strategic Bond

“This fund has a high government bond weight, so should do well if equity markets come off,” concluded James.

_{Photo by Jonathan Farber on Unsplash}