The debt ceiling is a legal cap established by Congress on the amount of money the federal government can borrow to finance its operations, designed to provide a check on government spending. The negotiations over raising the debt ceiling are often contentious with both parties trying to use the opportunity to advance their own agendas. These negotiations have been a fixture of U.S. politics since the debt ceiling was created in 1917, with recent contentious negotiations occurring in 2011 and 2013. The current negotiations are no exception.
Concerns expressed by investors are related to what happens if negotiations do not result in a resolution, as it could lead to temporary suspension of government services, delay of payments to vendors, government debt or a potential interruption of payment for Social Security or Medicare. The last two are unlikely as the U.S. Department of the Treasury can make payments by other means to avoid a default on debt obligations or key programs like Social Security. A recent editorial in Brookings goes a bit deeper on the contingency plan the Treasury put in place in 2011 when the country last faced a debt ceiling debate.
It is also worth noting that the flip side of the coin has also occurred in the past, when negotiations went more smoothly than expected or the debt ceiling was suspended, with that reduced uncertainty potentially resulting in a positive effect on investment markets. The important thing to remember is that the market prices in probabilities of both sides of the coin, and historically, the market has been better at assigning those probabilities than the smartest investors. The proof being that you see a lot fewer successful active investors than you would expect if such anticipation of markets was possible.
We take a long-term view. We do not recommend allocation changes around events like debt ceilings because we expect to live through many such events over our lifetime. Reducing stock market exposure across all these events would very likely reduce long-term wealth.
When events like this occur, one discussion worth having with our office is whether or not to increase your permanent emergency reserves and extended cash reserves. These reserves should be enough to allow you to weather periods of heightened market volatility, as drawdowns happen almost every calendar year, and yet most years are positive in whole.
