To watch or listen to this article, click here. (An update: The projected breach of the U.S. debt limit has been accelerated to June 1, 2023.)
In the last couple of “Capital Ideas” columns, I’ve mentioned that I expect a 10-percent stock market correction in 2023. Given the constant and countless flow of headlines and discussions of the upcoming U.S. economic recession (a narrative about 16 months old at this point), you would not be surprised that I’m not alone in that not-so-bold assessment. The list of Wall Street analysts, portfolio managers, day traders, financial professionals, and weekend economists who expect the stock market to revisit its October 2022 lows is longer than my left arm.
Unlike those prognosticators, I don’t believe it will be a recession that triggers a drop in stock prices; the spark will be debt ceiling negotiations. I’m not going to get into the politics of it. Not because I want to avoid offending one side of the aisle or the other, but because both sides are so dysfunctional it’s hard to track the progress (if any).
The debt ceiling (aka, the “debt limit”) is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past. Failing to increase the debt limit would have catastrophic economic consequences.”
The U.S. regularly spends more than it collects in revenue, and those shortfalls are called “deficits.” The U.S. Treasury borrows money to cover deficits by issuing new debt through government bonds. When the amount of borrowing hits the limit imposed by Congress, lawmakers must authorize new spending because the ceiling isn’t automatically increased.
The U.S. Treasury has nearly borrowed as much money as was allowed by Congress since the last time it raised the debt limit. Increasing the limit is procedural, and the amounts are arbitrary. The procedure allows Democrats and Republicans to flex for voters while simultaneously eroding America’s reputation of being orderly and able to pay its debts.
The government pays its debts by issuing government bonds. But if the Treasury doesn’t have the money to pay its bills, it will also be unable to pay interest on those bonds. The U.S. would be considered in default and would no longer be able to borrow money to fund itself. Remember that the Treasury’s biggest lender is its cousin, the Federal Reserve Bank. The U.S. government can never run out of dollars to pay its bills because the Federal Reserve Bank can create and loan however much the Treasury needs to fulfill its obligations.
Calamity, in this instance, isn’t an issue of solvency. It’s a matter of politicians barking at each other because they’re too self-important to devise a better method than facing each other down when the Treasury needs more money.
According to the Congressional Research Service, the debt ceiling has been modified 102 times since World War II (10 were decreases). Given the history of “successful” modifications, you could assess that the risk of default is low. However, the brinkmanship between the political parties is high, and the deadline is nigh.
There is no official deadline for when the Treasury will run out of money, but the current projection is June 1, 2023 (U.S. Treasury Secretary Janet Yellen recently advanced that date from an early estimate of mid-July). Negotiations could come down to the wire, delaying payments for an hour or days—an occurrence some call a “technical default.” Make no mistake: A technical default is a default.
In 2011, similar politicking over the debt limit broke out. Although Congress eventually resolved the 2011 debt ceiling crisis by passing the Budget Control Act of 2011 on August 2, 2011, some damage had been done. Standard & Poor’s downgraded the United States’ long-term credit rating from AAA to AA+, even though the U.S. did not default.
The equity markets didn’t care much for the process either. The S&P 500 dropped about 17 percent in about a month—almost half of that drop occurred up to the day of the debt limit raise and half in the following two weeks. It is amateurish to expect that the history of one data point is the design for the next. However, should that be the case for 2023, the October 2022 lows for the stock market would be revisited around mid-June 2023. If you’re looking for the silver lining, those pre-2011-crisis highs were recaptured six months later, and the market continued its rally for three years.
I expect a garden-variety correction. Dropping back to the 2022 lows, however, is less likely. I calculate the threshold of the market’s drop to be about 3,750 points on the S&P 500 because:
- Inflation peaked in June 2022,
- the Federal Reserve is near (or at) the end of its interest rate tightening cycle,
- and, after three-quarters of declining corporate earnings, profit growth will resume in the second half of 2023.
Could I be wrong on that? Sure. Political inaction could trump the fundamentals, cause investors to panic, and push down stock prices; however, the U.S. will ultimately pay its bills, and any pullback will occur as economic factors stabilize.
Although I anticipate the stock market to drop 10 percent, that’s not a given. If it does happen, it can’t be timed with any elegance. I’ve considered selling equity positions to hedge against the stock market’s reactions to the debt limit shenanigans. However, at this moment, I’ve opted not to. I already have some hedged positions in my investment portfolios, mainly utilizing flex options. I am uncomfortable with this strategy of holding through a correction because I don’t enjoy seeing the value of my portfolio decline. But, for now, I will maintain my hedging allocations and potentially use any decrease in stock prices as an opportunity to add exposure to unhedged equity.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
