11 Jul

Another Debt Ceiling Showdown Is on the Horizon

WRITTEN BY Mohit Oberoi, CFA

Debt ceiling showdown

Earlier this week, the Bipartisan Policy Center said that the US government could hit the debt ceiling in September. Previously, the Bipartisan Policy Center predicted that the country would hit the debt ceiling in October or early November. Shai Akabas, the group’s economic policy director, blamed lower tax receipts for the earlier-than-expected debt ceiling.

So, what exactly is the debt ceiling? As the Balance said, “The debt ceiling is a limit that Congress imposes on how much debt the federal government can carry at any given time. When the ceiling is reached, the U.S. Treasury Department cannot issue any more Treasury bills, bonds, or notes. It can only pay bills as it receives tax revenues.” Since the ability to issue more debt is thwarted under the debt ceiling, the US government could default on its obligations including paying interest on its outstanding debt.

Previous debt ceilings

The US has approached the debt ceiling in the past. Over the last decade, the country has approached the debt ceiling four times. In 2011, President Obama signed the Budget Control Act of 2011 just hours before the deadline. Standard & Poor’s downgraded the US rating from AAA to AA+. In 2013, the US approached the debt ceiling again. President Obama signed the Continuing Appropriations Act of 2014 and suspended the debt limit by almost four months.

When the debt ceiling was a few weeks away in 2017, President Trump suspended the debt limit by three months. In December 2017, the debt limit increased to $20.5 trillion. Last year, President Trump signed the Bipartisan Budget Act of 2018, which suspended the debt limit until March. The debt limit was restored at $22 trillion in March.

Where do we stand currently?

The Bipartisan Policy Center expects the debt ceiling to be hit at the beginning of September. The Senate will leave for recess in August. So, the Senate would only have a few days to avert a debt ceiling once it returns after Labor Day. The Hill reported that Nancy Pelosi, the speaker of the US House of Representatives, said, “We’ll see how those conversations go. We certainly do not want any default on the part of the full faith and credit of the United States of America.” She said, “That’s never been what we’ve been about, but there are those on the Republican side who have embraced that again and again. So, we’ll see.” Pelosi is reportedly slated to discuss the matter with Treasury Secretary Steven Mnuchin. The Democrats and Republicans would like to avoid a debt ceiling crisis amid the looming 2020 presidential election.

Perennial showdown?

The debt ceiling has been a perennial showdown in US politics. The impending debt ceiling would be the third debt ceiling that the country witnessed in the last few years. While every economy needs to have a debt ceiling, frequent showdowns need to be avoided. The frequent debt ceiling reflects over-optimism in the budget. According to the Bipartisan Policy Center, the tax revenues have been lower than expected this year. The US economy rose at a strong pace in the first quarter. However, we’re in an earnings recession. According to a FactSet report, S&P 500 companies are expected to report a 2.6% YoY (year-over-year) decline in their second-quarter earnings. The S&P 500’s earnings fell YoY in the first quarter. If corporate earnings fall on a yearly basis in the second quarter, it would be the first time since 2016 that the S&P 500’s earnings fall for two consecutive quarters. Lower earnings mean lower tax revenues for the government.

Another Debt Ceiling Showdown Is on the Horizon

Markets

US markets have looked strong this year. On Wednesday, the S&P 500 (SPY) crossed 3,000. Powell’s testimony raised the hopes of a rate cut. The S&P 500 had its best first half since 1997. Microsoft’s (MSFT) market capitalization rose above $1 trillion, while Amazon’s (AMZN) market cap is slightly short of $1 trillion based on yesterday’s closing prices. Apple’s (AAPL) market capitalization was $915 billion based on yesterday’s closing prices. Apple and Amazon form part of Berkshire Hathaway’s portfolio. Warren Buffett, Berkshire Hathaway’s chairman, donated $3.6 billion to charities including those linked to Microsoft’s founder Bill Gates. While Buffett invested in stocks like IBM (IBM) and Oracle (ORCL), he has largely shied away from tech stocks. Berkshire Hathaway exited Oracle and IBM.

Buffett’s views on debt

Several observers have a bearish view of the markets and economy amid rising US government debt and fiscal deficits. The annual fiscal deficit already crossed $1 trillion, which raised red flags for some economists. The US total public debt-to-GDP ratio is above 100%. The ratio was in the 60s before the 2008–2009 financial crisis. Since then, the debt as a percentage of the GDP has ballooned. The sharp rise in US debt made some economists apprehensive.

Buffett warned against doomsayers in his 2018 annual letter. Buffett said that the US government debt has risen 400x in the last 77 years. He also said that during this period, there have been Republicans and Democrats almost equally in the White House. Despite intermittent periods of despair, including wars and recessions, equities have delivered handsome returns. In March, Buffett said, “I’m not a fan of MMT — not at all.” MMT stands for modern monetary theory. Buffett also said in the interview that “We don’t need to get into danger zones, and we don’t know precisely where they are.” MMT proponents don’t see a problem with higher fiscal deficits and say that governments can print more money to pay off their debt.

Earlier this year, billionaire hedge fund manager Seth Klarman, who some hail as “the next Warren Buffett,” also pointed to the rise in debt following the 2008–2009 financial crisis. According to Klarman, “The seeds of the next major financial crisis (or the one after that) may well be found in today’s sovereign debt levels.”

Where’s the problem?

Looking at the approaching debt ceiling, it’s a multi-faceted problem. The approaching debt ceiling reflects that the government budget overestimated its revenue receipts. Investors need to keep an eye on the rising US government debt. The US’s fiscal deficit as a percentage of the GDP was 3.8% in fiscal 2018 compared to 1.1% in fiscal 2007. The deficit is expected to increase more this year.

A higher fiscal deficit is a concern during the longest economic expansion in history. The economic growth over the last decade has been led by accommodative fiscal and monetary policies. The scenario is similar across the globe. Fiscal and monetary policies never fully recovered to the pre-crisis era over the last decade. Governments and central banks would lack the arsenal if there’s another recession. Some economists think that the US-China trade war will lead to a recession. Read What’s Next In the US-China Trade War Saga to learn more.

The US-China trade war has already taken a toll on the sentiments. Companies including NVIDIA (NVDA), Micron (MU), Intel (INTC), and Broadcom (AVGO) have significant revenue exposure to China. NVIDIA, Micron, Intel, and Broadcom have seen an upward price action of 20.2%, 35.2%, 4.0%, and 10.0%, respectively, this year.

The recurring anxieties with the debt ceiling crisis need to be resolved. As the Bipartisan Policy Center said, “The United States needs to control its debt but, ironically, a debt limit is not the right way.”

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