US Debt Ceiling Woes Continue – Opportunities and Risks for Investors

President Biden is scheduled to meet with influential members of Congress on Tuesday to continue negotiations, but with neither side suggesting they’re budging so far, the fate of the US economy hangs in the balance.

According to Treasury Secretary Janet Yellen, if Congress doesn’t act soon, the U.S. might run out of money to pay its obligations within a matter of weeks, and the markets are already sounding the alarm.

Inevitably at the last minute, a deal will be negotiated that both the White House and Congress can somewhat live with, but how can investors protect their portfolios in the event of default and what could it mean for the US economy if the worst should happen?

The Debt Ceiling in Short

In order to cover the cost of government expenses such as Social Security and Medicare benefits, military wages, interest on the national debt, tax refunds, and other payments, the US government must borrow up to a certain limit. Because the US budget is always in deficit, in order to do this, the U.S. Treasury creates new debt by selling bonds to investors across the world.

The debt ceiling doesn’t provide permission to incur further debt, though. It just authorizes the payment of pre-existing statutory commitments made by previous Congresses and administrations of both political parties. Congress is responsible for suspending or increasing the limit, and in the coming weeks, members of both parties will likely demand concessions as they negotiate a solution.

Throughout history, Congress has consistently taken action in response to requests to increase the debt ceiling. Since 1960, the legislative branch of the US government has authorized such adjustments on 78 occasions, whether it was to permanently increase, temporarily prolong or modify the definition of the debt limit itself.

Since the United States has never defaulted on its debts, it is impossible to predict with complete certainty the severity of the economic and social consequences that would follow, but there are plenty of experts lined up to speculate.

Many believe the economy would basically collapse if the ceiling wasn’t raised, and it would set off a global financial catastrophe. It would be an event that would put people’s jobs and investments at risk, and plunge the United States into a deep economic hole just as it is beginning to emerge from the last recession.

It’s not the first time it’s taken an extended game of chicken to finally come to a compromise on the budget. Most recently, during a stalemate in 2011, the government’s credit rating was lowered from AAA to AA+ by Standard and Poor’s even though there was no default. This then increased borrowing rates and had a hand in devastating investments.

What’s All the Fuss About This Time?

The White House and congressional Democrats are insisting on an increase in the debt ceiling with no conditions attached. However, late last month, the U.S. House of Representatives approved a package to raise the government’s $31.4 trillion debt ceiling, which also calls for significant expenditure reductions over the next ten years.

The new bill isn’t anticipated to pass the Senate, and if it did, President Joe Biden, who eloquently labeled the proposed conditions as ‘wacko notions’ would veto it. Nevertheless, the partisan vote of 217 to 215 in favor of the plan gives Republican House Speaker Kevin McCarthy a victory and will give him negotiating power when he meets with Biden tomorrow.

The key takeaways from the House Republican proposal would be to reduce expenditure across the board by 8% in the next year and limit future increases to 1% annually.

Some Republican party leaders have claimed they would protect military and veterans’ programs from any cuts, although the proposal itself is vague on the subject. In contrast, President Biden has advocated boosting taxes on the most wealthy of Americans, but Senate Democrats have not come up with an alternative plan as yet.

Risks for Investors

According to the White House, significant market stress has already been observed this year in correlation with debt ceiling tensions. The yields on Treasury bills with maturity dates close to when the government may potentially default have increased significantly, effectively increasing the cost of borrowing for the government and, consequently, the burden on taxpayers.

Analysts Wendy Edelberg and Louise Sheiner from the Brookings Institution recently argued that falling stock prices, a drop in consumer and business confidence, and a reduction in access to private credit markets are all highly likely outcomes should expectations regarding a potential default continue to worsen.

Opportunities for Investors

Many experienced traders and investors will tell you that this latest occurrence of debt ceiling stress isn’t the first and won’t be the last. Most recommend maintaining your long-term investing strategy regardless of the short-term fluctuations, but there are ways to help you shore up your portfolio.

Think about the Swiss franc, the Japanese yen, and gold as examples of prestigious currencies and commodities to help add an extra layer of diversity.

In addition, bond yields worldwide have increased, making bonds issued by countries other than the United States an attractive source of income and security.

Consider CDS, or credit default swaps. This kind of financial derivative enables a shareholder to exchange or counterbalance their credit risk with that of another shareholder. The lender purchases a CDS from another investor who promises to pay them back if the borrower fails in order to swap the default risk. There is now a high demand for them.

Also look into high-quality foreign equities, which are already seeing improvement from China’s reopening, Europe’s improved energy dynamics, and increased exposure to the real economy, as this may offer relative protection if stocks worldwide take a knock during a potential US economic shock.

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