On May 1, U.S. Treasury Secretary Janet Yellen communicated to Congress that the Treasury may be unable to meet its debt obligations as early as June 1 should the government not vote to raise or suspend the debt limit before that time. With June 1, or what is now often referred to as the “X-date”, fast approaching, investors have understandably become increasingly nervous about what may result should we get to that date with no deal in place.
A U.S. government default would be an unprecedented event and, while it’s impossible to know what will transpire, we wanted to communicate some of our thoughts and what we’ve heard from some of our cash and fixed income managers over these last few days.
This note comes with the obvious caveat that information is changing rapidly and can become outdated quickly.
With that disclaimer we wanted to do our best to summarize and attempt to answer some of the questions we’ve been getting from investors.
Is the fact that this is coming “down to the wire” a surprise?
No, that part is probably the least surprising aspect of what is happening. Once the debt ceiling was reached in mid-January and both political parties staked out very different, hard-line positions the current predicament and the last-minute nature of it was somewhat inevitable. Neither party has a political incentive to compromise before the 11th hour, much like in 2011 when a deal was struck just two days before the Treasury estimated it would run out of funds.
What are the various ways this could play out?
In our estimation and summarizing what we’ve heard from folks closer to the situation there are three basic scenarios.
- A deal comes together this week and gets voted on and signed next week before the June 1 deadline. This is still considered the most probable outcome and certainly the preferred route.
- The parties aren’t able to strike a deal to raise the debt limit but are able to agree on a short-term extension or suspension of the debt ceiling. For this to be a reality the parties would likely have to have agreed to a framework for continuing discussions.
- A no deal scenario pushes us past June 1 and the U.S. exhausts all its flexibility in meeting its debt obligations and/or has to make choices in regard to which debts it’ll prioritize in making payments on. We’ll dig deeper into this one in a follow-up question.
How hard of a deadline is June 1?
That’s an interesting question as for much of this year we’d heard the Treasury could run out of funds anywhere from early June to late August. The early June period became more likely recently due to lower than projected tax receipts in April. While Janet Yellen has stated that she believes the government could run out of funds “as early as” June 1, one of the managers we spoke with believed that the government was unlikely to default on that date. They believed that the government would still have some flexibility to make payments and by their estimation somewhere between June 5 and 8 was the real danger point.
It’s worth adding that with tax estimate payments due by mid-June if the government were somehow able to avoid default until then things could get pushed out another month or two.
If a deal is announced this week is that the end of it?
Hopefully that would be the end of it, but there is still some risk until everything is voted on and signed. The most likely snag would be with the House Republicans. If House leader Kevin McCarthy agrees to a deal with the White House, but doesn’t have enough support from his own party he’ll need some support from Democrats to push things through.
What happens if there is no deal struck and the government runs out of funds?
As we mentioned before this would be unprecedented, so it remains a bit of a guessing game. The “best guess” by analysts points to the government prioritizing payments on Treasury debt and delaying other payments. It’s unclear what specifically would be impacted and in what order but included in that “other payments” are potentially things like Social Security, military benefits, and Medicare. That may help avoid a technical default on U.S. Treasuries but would still have damaging consequences for millions of Americans either directly or indirectly.
If there is no deal by June 1, then what?
As it was described on one of the calls we participated on, if a deal is not struck the pressure to come to an agreement will increase exponentially and globally. This is my own opinion, but it’s hard to see a stalemate lasting more than a day or two once we reach that point where Social Security checks or Medicare payments are potentially not going out. Public outcry will be swift, fierce, and cross party-lines, putting tremendous pressure on both parties to find a solution – and quickly.
What is the stock market expecting?
As of now the market seems to still have confidence that a deal will happen. The S&P 500 is currently right at its high for the year and credit default swaps on U.S. Treasuries (a gauge of the likelihood of a default) indicates only about a 3-4% probability of default. One of the analysts we heard from today said he put the probability of a deal or a temporary suspension of the debt ceiling at about 90%. The likelihood of a default is clearly not zero and higher than it ever should be, but markets are still acting as if a deal will happen.
Related to this I’ll add that yes, markets are not pricing in a default. If that is the path this ultimately takes, then markets will almost certainly react negatively. The flip side of that, of course, is that even if markets are at year highs, there are plenty of investors sitting on the sidelines waiting to see if a deal is struck before putting capital to work. A deal could very well lead to another leg up or a relief rally.
Given all the uncertainty, is there anything we could be doing or should be doing in portfolios?
There are certainly things one could do, but those actions come either with an explicit cost (hedging) or a potential opportunity cost (going to cash). Both may shield the portfolio from some near-term volatility, but they also are likely to cost investors in the long run. Timing the “ins and outs” of the market is rarely ever advisable or profitable. The potential for a painful selloff is there and we don’t want to downplay the risks of that occurring, but the most likely outcome is still that a deal is made or that there is some sort of short-term compromise. Rather than guess at what might occur or try and play both sides, we think the best defense is to stay diversified and focused on the long term. I’ll add that should markets selloff, we’ll be looking for opportunities to take advantage of that weakness and volatility.
Given all the unknowns and the state of our government we don’t fault anyone for being skeptical that a deal will happen or for being nervous about their investments. One thing we do think investors should be confident in though is that an increase in the debt ceiling is a matter of when, not if. As one of our asset managers cleverly put it “the passage of a debt ceiling increase is like the passing of a kidney stone; we all know it will pass, the question is just how painful will it be.” We do hope you found this information helpful and thought we’d close with some more positive thoughts:
- The most likely outcome still revolves around a debt ceiling increase or suspension
- While time is indeed short, there may be a little more time than the June 1 deadline suggests
- Even if no deal is reached, payments on Treasury debt, Social Security, Medicare, etc…will be delayed, not cancelled
- Any period of delayed payments or technical default is likely to be short-lived
- Diversification and a long-term focus is still the best defense for periods of volatility
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.