As head of financial and economic research at Buckingham Wealth Partners, I’ve been getting lots of queries from investors concerned about the risk of the U.S. defaulting on its debt. In this article, I’ll explain the situation, point out the risks and provide strategies investors can consider to address them.
The Current Situation
The U.S. government has a self-imposed borrowing limit known as the debt ceiling. When that ceiling is reached, the Treasury Department cannot issue any more debt—it can only pay bills as it receives tax revenues. We reached the debt ceiling on January 19, 2023, when the national debt crept up to above $31.4 trillion. The current ceiling was set in December 2021—when it was raised by $2.5 trillion. Until Congress increases it again, the Treasury Department is relying on extraordinary measures to meet the government’s obligations. These measures cannot go on indefinitely, and the government will be at risk of default sometime later this year. If the ceiling isn’t raised or suspended, the Treasury Department would not be able to issue more Treasury bonds. The government would be forced to choose between paying federal employees’ salaries, Social Security benefits or the interest on the national debt. If it doesn’t pay that interest, the country would default.
When considering what could happen if the country were to default, it’s helpful to examine our trusted videotapes. Here is a quick review of the last episode when default was at risk.
In January 2013, Congress threatened to not raise the debt ceiling. It wanted the federal government to cut spending in the fiscal year 2013 budget. Better-than-expected revenues meant the debt ceiling debate was postponed until that fall. On September 25, 2013, the Treasury Secretary warned that the nation would reach the debt ceiling on October 17. On the first day of fiscal year 2014 (Oct. 1, 2013), the government shut down because Congress hadn’t approved the funding bill. On October 17, 2013, Congress finally agreed to a deal that would let the Treasury issue debt until Feb. 7, 2014. The Council of Economic Advisers estimated that the combination of the government shutdown and debt limit brinksmanship may have resulted in 120,000 fewer private-sector jobs created during the first two weeks of October and slowed economic growth by as much as 0.6%. Yields on Treasury bonds remained virtually unchanged over those 17 days, and the S&P 500 Index actually rose about 1.5%. Thus, investors who took action to avoid risk incurred expenses in doing so and missed out on positive equity returns.
Although it was not the result of a debt ceiling crisis, the last government shutdown, running from December 22, 2018 until January 25, 2019 (35 days), was the longest in history. It occurred when the 116th Congress and President Trump could not agree on an appropriations bill to fund the operations of the federal government for the 2019 fiscal year or a temporary continuing resolution that would extend the deadline. Over this 35-day period, the S&P 500 rose about 2.7% (indexes are unmanaged baskets of securities and cannot be directly invested in nor are they indicative of trading in an actual portfolio). Treasury bond yields were virtually unchanged. Once again, investors who acted on their fears of default incurred expenses and missed out on positive equity returns.
These two episodes provide important lessons about having a well-thought-out plan that already incorporates the risks of such inevitable negative events, so you don’t have to consider taking actions that can turn out to be expensive. Unfortunately, most investors have selective memories when it comes to the actions they contemplated based on their fears and tend to forget the losing trades and remember the ones that worked out well.
Having reviewed the historical evidence, we can now consider the risks to markets a prolonged default represents. We begin by noting that financial markets dislike uncertainty. When uncertainty increases, risk premiums demanded by investors increase, driving up the price of risk assets related to economic activity and driving credit risk down.
Economic Effects of a Default
The macroeconomic effects of a federal debt default are extremely uncertain, ranging from a temporary blip down in real activity if the default is short-lived to a major crisis that pushes the economy into recession—and potentially deflation if the crisis is prolonged.
For investors, uncertainty increases the potential dispersion of possible outcomes. And in the case of a U.S default, there are no precedents to rely on to help forecast what could happen. Although other countries have defaulted on their sovereign debt, those defaults occurred in situations when countries could not feasibly continue to service their debt. Failure to raise the U.S. federal debt ceiling would be a voluntary decision to stop meeting the government’s obligations. In addition, other nations that defaulted did not have the world’s leading reserve currency. As such, it acts as the benchmark against which all risk assets are measured. With that in mind, we’ll consider some possible, if not likely, economic scenarios.
Economic Risks of Default
Yields on Treasury securities could rise noticeably if the debt limit impasse dragged on for weeks. As one example, it could conceivably lead investors to demand a premium similar to that paid on AAA corporate bonds. As of this writing, the spread difference between long-term Treasuries and AAA corporate debt was about 55 basis points. On $31 trillion in debt, that’s an incremental interest cost of about $165 billion.
Not only could Treasury yields rise significantly, but because a prolonged standoff would increase economic uncertainty, private interest rates could rise sharply. Rising interest rates and rising risk premiums would in turn push stock prices down significantly.
In the case of a prolonged default, liquidity in financial markets could be severely impaired. It might increase the reluctance of investors to hold Treasury securities and dollar-denominated assets in general, leading to a higher risk premium on all U.S. assets and a decline in the dollar, with negative impacts on inflation.
Given a default and assuming the Treasury prioritizes its payments to cover all scheduled net interest payments, federal spending on such important programs as Social Security, Medicare/Medicaid, Veterans Benefits and other transfer programs would have to be temporarily reduced. While shortfalls in disbursements would probably be made up later, consumer spending would fall in the meantime. The multiplier effects could lead to a sharp fall in the economy.
FOMC Weighs In
During the debt crisis of 2013, the Federal Open Market Committee (FOMC) issued a report that showed the results of a simulation of its economic model in which the economy is hit with a variety of shocks to financial markets, income flows, government operations and household and business confidence. They assumed an impasse would be short-lived (about six weeks). Their main findings were that:
- A one-month furlough of workers would result in a loss of real federal spending (and hence real GDP) that would not be made up. This effect would shave 0.75 percentage point from the annual rate of real GDP growth in that quarter but add the same to GDP growth in the following quarter;
- Ten-year Treasury yields would rise about 80 basis points and BBB corporate bond yields would increase about 220 basis points;
- Stock prices would fall by about 30%;
- The dollar would drop by about 10%;
- The deterioration in financial conditions would be accompanied by a tightening in credit availability as well as a reduction in household and business confidence;
- Private spending would fall sharply, about one-third to one-half as large as the fall during the Great Recession (late 2008 and early 2009);
- The economy would fall into a mild recession for two quarters, with the unemployment rate rising to almost 8%;
- The slowdown in economic activity would allow inflation to fall; and
- Monetary policy would remain accommodative.
The FOMC report noted that they expected the various shocks to fade away over the course of the following two years. Thus, they concluded there likely would be no permanent rise in term/risk premiums on Treasury debt, nor any sustained rise in the country risk premium applied to holding dollar-denominated assets.
Summarizing, the risks to the economy and financial markets of a prolonged default are almost unthinkable, especially given the simple solution. That is why we have never had a default. Unfortunately, given the current situation, with a narrowly divided Congress and a small number of Republicans (five) who have vowed to get concessions before agreeing to an increase in the debt ceiling, treating even the highly unlikely as impossible is a mistake that investors should not make. The question is: What if any actions should one consider taking given the risks?
As always, economic theory provides the way to think about the problem. First, diversification of risk is always the prudent strategy. With U.S. equities currently making up about 50% of the world’s market capitalization, investors should consider having 50% of their assets diversified into international equities, with about three-fourths of the remainder allocated to developed markets and one-fourth to emerging markets. And while one’s labor capital is not on any financial balance sheet, it is an important asset for those employed (and the younger one is, the more important that labor capital is as a percent of all assets). Thus, younger U.S. workers might consider an even somewhat higher allocation to international assets. Offsetting the diversification benefits, investing in the U.S. is typically a bit cheaper to implement and is also more tax efficient in tax-advantaged accounts. Those facts argue for a slight tilt toward U.S. assets. At any rate, investors concerned about the risk of default can increase their allocation to international assets.
While we don’t recommend engaging in market timing based on valuations, they are the best predictor we have of future real expected returns, with the E/P ratio (the inverse of the P/E ratio) providing important information. U.S. stocks dramatically outperforming international stocks over the past decade has resulted in U.S. valuations being dramatically higher—future expected returns are now much lower than for those of international stocks. For example, Morningstar shows that Vanguard’s Total U.S. Stock Market Index Fund (VTSMX) has a P/E of 16.4 (E/P of 6.1%). In contrast, its Developed Markets Index Fund (VTMGX) has a P/E of just 11.6 (E/P of 8.6%), and its Emerging Markets Index Fund (VEIEX) has a P/E of just 11.2 (E/P of 8.9%). Thus, the real expected returns to VTMGX and VEIEX are currently 2.5% and 2.8% higher, respectively, than for VTSMX. Investors concerned about the risks of a U.S. default can diversify that risk while potentially increasing their expected (not guaranteed) return.
Another approach is to diversify a portfolio by increasing exposure to risk assets that do not have exposure to U.S. economic cycle risks. Strategies investors can consider include reinsurance (funds such as Stone Ridge’s SHRIX and SRRIX and Pioneer Amundi’s XILSX). These funds can benefit from rising interest rates, as the collateral they hold is invested in short-term Treasuries and long-short multi-asset factor funds, such as AQR’s QSPRX and QRPRX. While useful in diversifying a portfolio, reinsurance and other alternative strategies involve a high level of risk, including liquidity risk.
Investors also can consider adding or increasing their exposure to trend-following strategies such as AQR’s AQMRX. My Wealth Management article on January 24, 2023 examined the empirical evidence on two tail-hedging strategies, buying puts and trend following, which found that, while puts are effective when the tail risks are very short-lived but disastrous when they are long-lived (e.g., during the GFC), trend following provides strong hedging benefits when the tail risk is long-lived, and diversification benefits over the long term.
One final point before closing: For the fixed income portion of your portfolio that is designed to be the anchor that keeps the ship safe in port during a storm, an intermediate maturity (typically four to five years) investment that balances the risks of inflation and reinvestment (such as government bonds, FDIC insured CDs, and AAA/AA municipal bonds) is the prudent strategy.
It’s critical that investors not make the mistake of “resulting”—judging the quality of a decision based on the outcome, rather than on the quality, of the process. Engaging in resulting can lead investors to abandon even well-thought-out plans. Robert Rubin, former co-chairman of Goldman Sachs, advised investors: “Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.”