“It’s never paid to bet against America.” — Warren Buffett
What if the US Government Defaults on its Debt?
If the U.S. was to default on its debt obligations, it would cause investors to flee from U.S. Treasuries, leading to a decrease in confidence in U.S. government debt and the U.S. Dollar (USD) as being the medium of exchange for the global economy. In turn, this would negatively affect other markets — interest rates would increase, making borrowing money and purchasing other investments more costly. In addition, a decrease in confidence in U.S. government debt would also lead to extreme volatility in the global capital market akin to the 2008 global financial crisis. The long-term effects of debt-ceiling debates are that inflationary expectations are kept well anchored.
As Nobel Prize-winning economist Thomas Sargent suggests, “persistent inflation is everywhere and always a fiscal phenomenon.” Simply put, debt-ceiling debates help ensure that inflation is kept in check. A current study from the St. Louis Federal Reserve concluded that fiscal policy added 2.6 percent to the level of inflation in the U.S. and 2.3 percent in Canada. In an environment where many have wrongly concluded that inflation is caused by the private sector and low unemployment—and not supply shocks or fiscal policy—ensuring that checks and balances like the debt-ceiling debate are in place, will help keep inflationary expectations well-anchored close to two percent.
The U.S. government will not default on its debt. The simple reason is that it has a monopoly on printing U.S. dollars (USD). Despite political gamesmanship and the concerns put forth by many, given the extensive level of debt and spending that the U.S. government does, it has never defaulted on its debt — even during times of economic hardship such as the Great Recession. Additionally, although it can produce new money, it is prudent that the U.S. government monitors debt levels to ensure confidence in the soundness of the USD. While in theory, there could be replacements for the USD as the medium of exchange in the global economy. Ultimately, the U.S. government will not default on its debt when it has a monopoly on printing U.S. dollars so long as the global economy has confidence in the policymakers in Washington, D.C. and Wall Street, and the U.S. maintains its innovative and technological leadership — which we don’t see changing.
Keynes’ Warning at Bretton Woods
At the 1944 Bretton Woods Conference, British economist John Maynard Keynes warned the U.S. about its massive wartime borrowing—a looming debt crisis could have catastrophic effects on the global economy and push the world back into a depression. The fears of deflation and secular stagnation of the 1930s were at the forefront of everyone’s mind. Keynes was quick to point out that although the end of the war created some much-needed optimism, the economic conditions of the day presented a significant challenge. He told conference delegates that the vast amount of past borrowing and the vast amount of future borrowing could not be conceivably met by taxation without plunging the world into a deep depression.
The cause of Keynes’ fear was rooted in the fact that the U.S.—the world’s largest economy—had racked up massive amounts of debt during the Second World War, with much of the money borrowed from foreign investors. With all the money owed to foreign banks, Keynes warned that the U.S. would have to confront an “ensorcellment” of debt which would only become more and more challenging to pay off. In addition to the looming debt crisis, Keynes also warned that the monetary system at the time—based solely on the gold standard—was becoming antiquated and unable to manage world financial markets effectively. One of the primary reasons he proposed the creation of the International Monetary Fund, the Bank of International Settlement, and the International Bank of Reconstruction and Development was to create a more flexible and secure global finance system. Almost 80 years later, these institutions, and the place of the USD as the medium of exchange in the global economy, are being challenged. Keynes also suggested that Central Banks should seek to maintain low interest rates to stimulate economic growth and avoid pushing countries into debt. He said that international cooperation and better economic coordination were essential to prevent a debt crisis.
Debt Levels Today
In the aftermath of the Covid-19 pandemic, debt levels are at an extreme. With the rapid rise of interest rates by the Federal Reserve, interest payments on the U.S. debt is equivalent to the defense budget. More specifically, if the Federal Reserve continues to raise rates, interest payments on U.S. federal debt will eventually top $1 trillion. Ultimately, Keynes’ caution at the Bretton Woods Conference proved prophetic. In the ensuing years, the U.S. did begin to experience a significant debt crisis, which necessitated a series of measures to deal with the problem. To wit, the debt-ceiling crisis so many are concerned about today, has been with us since the end of the Second World War. And through all the turmoil that has followed, the U.S. capital markets are the deepest and most transparent in the world, and the U.S. leads in innovation and research. True: deficit spending needs to be kept in under control. True: long-term inflation is mostly a fiscal policy problem, not a monetary problem. True: there will be a high degree of contentious political deception. But in the end, a deal will be made and the government will pay its bills in a non-inflationary way. Investors should view any market dislocation as an opportunity to accumulate shares of high-quality assets that may temporarily go on sale.
Debt Ceiling: A Short History
The debt-ceiling is a legislative limit on the ability of the U.S. government to borrow money from the public. It usually takes the form of a statutory limit set by Congress on the amount of money the U.S. Treasury is allowed to borrow. It does not limit spending, merely how the U.S. Treasury can finance it. It has become a topic of debate in Congress, with many arguing that the debt-ceiling should be raised. In contrast, others say that the government should reduce deficit spending instead. It is one of the more politically charged fiscal debates.
Debt-ceilings first appeared in the U.S. in 1790 when the First Congress created a maximum level of $75 million to fund the operations of the newly formed U.S. government. This cap on total debt, which was increased periodically by Congress over the years, was intended to ensure that the government could only borrow money within certain limits, thereby preventing it from going too deeply into debt. By 1917, the First World War had pushed the debt limit above $12 billion, a number that Congress could no longer efficiently manage, so the modern budget discipline system was created. In addition to creating the debt-ceiling, Congress also established a spending ceiling with war and the demands of British creditors in mind. This allowed Congress to set a level of government spending each fiscal year, with any spend above this figure requiring Congressional approval. This meant that any bill that increased spending had to be voted on through Congress.
The debt-ceiling has been used to both ensure that the U.S. government can fund its operations and to limit its borrowing, but it has also been used as a political tool. In recent years, disputes over the debt-ceiling have intensified, with Republicans and Democrats frequently at odds over how large the ceiling should be and whether it should be raised. The political nature of the debate has meant that the debt-ceiling has been a contentious issue, with no clear consensus on its implications or how it should be handled.
Recent Events
Since 1995, the U.S. has experienced numerous debt-ceiling crises. Each one has had different levels of effect on the stock market. Generally, the stock market has reacted to the debt-ceiling crisis with short-term uncertainty and volatility. Over the long run, however, the market seems to recover, often with positive returns.
In October 1995, the U.S. federal government shut down due to a budget impasse between Congress and President Clinton over the national debt limit. The shutdown lasted for more than two weeks and immediately impacted markets—stock prices initially dropped for four straight days. The day after the shutdown began, the Dow Jones Industrial Average fell 62 points, the Nasdaq Composite Index dropped 2.1 percent, and the S&P 500 dropped 1.1 percent. Over the next week, the S&P 500 dropped an additional 3.3 percent. However, the markets soon regained their composure. By the end of the crisis, the Dow had gained 20 points, and the S&P 500 had recovered its losses and ended the month slightly up. In the longer term, the crisis had even less of an effect. Over the next year, the Dow increased by 8.5 percent, and the S&P 500 rose by 17.5 percent.
2011 USA Downgrade: A Closer Look
In August 2011, a more significant debt-ceiling crisis occurred. Standard & Poor’s downgraded the U.S. government’s credit rating for the first time in history, causing stock prices to fall significantly. The Dow dropped 635 points the day after the downgrade, and the S&P 500 dropped 6.7 percent. Over the following months, the markets continued to decline. By the first week of October, the Dow had dropped over four percent, and the S&P 500 had fallen nearly nine percent since the downgrade. However, the market soon began to rebound and the returns over the next 12 months were substantial, with the Dow and the S&P 500 increasing close to 30 percent by the beginning of the following October. Overall, the stock market has responded to debt-ceiling crises with uncertainty and volatility in the short-term. However, the long-term effects seem minimal and the market has often quickly recovered. At the end of 2011, the S&P 500 total return was 2.11 percent, and the Nasdaq 100 was 3.61 percent.
2013 Obama Vs. Congress: Round 2
By the end of 2012, the U.S. had reached its statutory debt limit of $16.394 trillion. This limit was achieved due to government spending, including a decrease in tax revenue and the implementation of stimulus spending after the 2007-08 financial crisis. The 2013 crisis culminated in a 16-day government shutdown in October 2013. The debt limit was eventually raised as part of a deal between the White House and Congress that also included a reopening of the federal government at reduced spending levels, thereby avoiding default on U.S. debt payments. The debt-ceiling crisis became a major source of uncertainty and market volatility. From May to June 2013, the S&P 500 index fell by 5.8 percent in anticipation of the debate and negotiation surrounding the debt-ceiling. During the same period, the 10-year U.S. Treasury note yield dropped by nearly 50 basis points, signifying a sharp decline in investor confidence. But after the dust settled, the S&P 500 total return for 2013 was 32 percent, and the Nasdaq 100 total return was 38 percent—reinforcing our thesis that the short-term volatility the debt-ceiling crisis provides investors, is an opportunity.
What Should Investors Do?
Equity markets tend to have a 10 percent correction every year. Those that prepare for such an event, take advantage of buying high-quality assets that are on sale. A debt-ceiling volatility event may very well happen in 2023, providing the excuse of a short-term market correction. That said, never underestimate the ability of House Speaker Kevin McCarthy and President Biden to cut a deal. Our bullish view of the equity markets in 2023 is predicated on the fact that the era of fiscal policy adding to inflation is over. The debate over the debt-ceiling should provide much needed fiscal restraint, which should help inflation continue its long march down to the desired target of the Federal Reserve. We continue to disagree with consensus and suggest investors should continue to position for a good year for risk assets.
If there is any good news that can come with high inflation rates, it may be the resulting cost-of-living adjustment. Each year, certain personal income tax and benefit amounts are indexed to inflation using consumer price index (CPI) data. With inflation reaching 40-year highs in recent times, the adjustment is one of the largest in many years.
Many adjustments will take effect on January 1. For instance, the TFSA annual dollar limit will increase from $6,000 to $6,500 for the 2023 year. Other adjustments take place on July 1, such as income-tested benefits like the goods and services/harmonized sales tax credit and the child disability benefit, as this date coincides with the beginning of the program year for these benefits.
The Impact of Inflation on CPP Benefits
Canada Pension Plan (CPP) benefits are influenced by inflation in two ways. First, they are indexed to CPI using a measure over the 12-month period ending October of the previous year. Second, CPP is also adjusted based on the year’s maximum pensionable earnings (YMPE), an amount indexed to wage inflation. Over recent times, increases to the YMPE have been significant: 4.94 percent in 2021 and 5.36 percent in 2022. This was largely due to the pandemic, when the services industry suffered and fewer people worked in lower-paying jobs, pushing up average weekly earnings.¹ Increases in inflation may have a particularly significant impact on CPP benefits the longer you wait to start.
The Timing Decision Can Further Enhance CPP Benefits…
As a reminder, the standard age to start CPP is 65, but you are able to begin as early as age 60. Most people choose to start early,² and if you start receiving CPP benefits before age 65, payments will decrease by 0.6 percent each month to a maximum of 36 percent (if you start at age 60). However, if you start after 65, payments increase by 0.7 percent each month, to a maximum of 42 percent (if you start at age 70 or after). This increased payment percentage from starting CPP later further amplifies future increases to the CPI and YMPE.
…And the Difference Can Be Significant
A recent analysis shows just how significant the impact can be by waiting.³ It looks at an individual who started CPP at age 60 in January 2020, with a decreased benefit of 36 percent (0.6% X 60 months). Assuming the maximum CPP pension amount of $1,175.83 in 2020, she received $752.53. Had she waited a year and started at age 61, she would have received $857.07 (a 28.8 percent decreased benefit from $1,203.75). If she waited until age 62, she would have received $982.81, or 30.6 percent more than if she started at age 60.
The table shows the potential increase over time, based on actual 2021 and 2022 figures. It assumes future CPI adjustments (after 2022) of 2 percent and maximum retirement pension increases of 3 percent based on existing actuarial assumptions.
By these calculations, at age 90 an individual would have a cumulative pension that is 83 percent larger by waiting to start at age 70, compared to starting early at age 60.
Of course, many factors should be considered when deciding when to begin CPP, including expected longevity, the impact of income-tested benefits, the need for income and more. However, the impact of inflation may be one compelling reason for individuals to consider waiting to begin CPP benefits.
The information contained herein has been provided for information purposes only. Graphs, charts and other numbers are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information has been provided by J. Hirasawa & Associates and is drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. This does not constitute a recommendation or solicitation to buy or sell securities of any kind. Market conditions may change which may impact the information contained in this document. Wellington-Altus Private Wealth Inc. (WAPW) and the authors do not guarantee the accuracy or completeness of the information contained herein, nor does WAPW, nor the authors, assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Before acting on any of the above, please contact me for individual financial advice based on your personal circumstances. WAPW is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. ©️ 2023, Wellington-Altus Private Wealth Inc. ALL RIGHTS RESERVED. NO USE OR REPRODUCTION WITHOUT PERMISSION
