“May we never forget that freedom isn’t free.” – Unknown

By Bruce Thompson on May 26, 2023

We wanted to send you a few follow-up comments on the debt ceiling and wish you a happy and thoughtful Memorial Day. The holiday is an occasion for reflecting on the lives of those who sacrificed so much lest we ever forget that freedom is far from free. Yet, over the years it also has come to mark the unofficial beginning of summer and all the wonderful possibilities that entails with family and friends.

Given that duality, it perhaps is fitting that Memorial Day comes at that flip of the calendar when this year, as in so many years past, the brilliant and yet at times flawed qualities of our form of government are on full display in the political wrangling over the budget and debt ceiling. It is chaotic and concerning but somehow, notwithstanding 79 debt ceiling battles since 1917, when Congress first imposed a limit on federal debt, it all works out. Obviously, the economy and markets have prospered mightily despite the tumult.

Until 1974, the President dominated the budget process, but this changed with the passage of the “Budget Control Act,” Nixon’s last legacy, which shifted the focus to Congressional committees and made the process less capable of reconciling competing demands and more prone to fiscal crises.

Prior to 1976, the Fed Gov’t had never ceased operations for lack of funding. Since then, the process has become more contentious and there have been 22 partial or complete government shutdowns in 47 years – that’s nearly once every two years on average.

We understand that this may be worrisome, but you should keep in mind that debt ceiling events and government shutdowns are not new and that there are no definitive historical market patterns around them that investors can operate on.

That’s something you should keep in mind when reading “the sky is falling” media articles suggesting you should reallocate your portfolio around debt ceiling miasma. That’s what many analysts infer in articles titled like this, “Debt Ceiling Crisis: What You Should Do With Your Money Now.” The illogical conclusion of that, if you can even call it a portfolio strategy, would be swapping your portfolio around every couple of years. Brokers and Uncle Sam would appreciate it, but in all likelihood, you would be poorer.

In the last 30 years, the debt ceiling has boiled into a full blown crisis five times — 1995, 2011, 2013, 2017, and 2023. The returns for stocks and bonds in each of those years are as follows:

Here is a graph of the S&P 500 Index since the beginning of 2011. As you can see, there was a correction in 2011, but the market rebounded sharply beginning in Q3 of that year and it nearly doubled by 2015. During the 2013 government shutdown/threat of default/downgrading of US credit rating by one agency, the market rose steadily all year long, as it did amid the 2017 debt ceiling battles. Over the entire period from 2011 to today, the S&P rose from about 1,300 to 4,100 today!

It is important to acknowledge that the market returns illustrated didn’t happen in a debt ceiling vacuum – there were other factors at play. In 2011, for example, the markets were also concerned about the Euro Zone debt crisis and defaults in countries like Greece and Italy. And over the period from 2011 to 2017, the markets generally were recovering from the mortgage crisis correction in 2007-09.

This presentation is not meant as any kind of a prediction about the future course of the market, but rather a commentary on why it is critical to think long-term and beyond short-term concerns and to stay diversified. Debt ceiling issues arise every couple of years or so, following the cadence of House elections, and occasionally they cascade into serious events. But changing a portfolio around in response may result in getting “whipsawed” and missing out on critical returns, not to mention that it isn’t very tax friendly.

Caveat emptor — switching into asset classes often offered as alternatives for your money in times of conflict can lead to not only missing out on future stock and bond returns but also losing money on the new investment. Gold is one example. In 2011, gold rose from about 1,500 to 1,800 during the crisis. But in the following 4 years, it dropped to 1,100! In 2013, the year of the last government shutdown, the yellow metal dropped 28%. Today gold is at 1,977, marginally higher than it was in 2011. The bottom line is that gold’s record as a diversifier during fiscal crises may not be so shiny.

Perhaps because we’ve seen this movie many times before, the markets so far this year have taken the uncertainty in stride – the Total Stock Market Index is up 7% and the US Bond Index is up 2%.

However, it makes sense to prepare mentally for volatility ahead even as and if an agreement is reached; much depends on the timing and details. In 2011, stocks dropped about 6% before the debt ceiling was raised. Counter to what you might expect, stocks dropped about another 10% after news of the agreement on concerns that budget cuts might lead to a recession (which ultimately did not happen.)

Also, because the US Treasury has had to operate recently with a lower level of cash holdings, once the debt ceiling is raised it will have to borrow heavily to replenish those reserves, which could lead to short-term liquidity dislocations and volatility in markets.

Political soothsaying is a low-probability business and not something to rely on in making portfolio decisions. But it is worth recognizing that in 2011 Republicans had a 24-member majority in the House, having swept in on a Tea Party mandate to cut spending. Currently, Republicans have a House majority of just 4, and not only were budget cuts not a focus in the 2022 mid-term elections, Medicare and social security remain popular across both parties, especially among older people — who also happen to vote.

With such a skinny majority, House Leader McCarthy cannot afford to lose more than a handful of members, which will be a harder proposition (for donors too) amid economic fallout and market weakness.

My advice to stay the course and stay diversified, as always, presumes that you have appropriate risk allocation to begin with and that you have sufficient cash reserves to meet planned or contingency needs during a potential storm.

Please don’t hesitate to call if you wish to discuss. Meanwhile, we will be looking for investment opportunities that may arise from market volatility.

In closing, our government process is far from perfect but, to paraphrase Winston Churchill, it is better than the alternatives! As we reflect back this Memorial Day, it is easy to smooth over history and forget that our success has often come at the cost of messy politics and conflict. Somehow it all works as evidenced by our prosperity and wealth creation over the years.  

Knowledge is power and here are some articles about the debt ceiling you might find informative.

Other sources: CFA Institute: Stocks, Bonds, Bills, and Inflation. https://www.cfainstitute.org/en/research/foundation/2021/sbbi-2021-summary-edition. Dec. 31, 2022.

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