The debt ceiling is a legal cap established by Congress on the amount of money the federal government can borrow to finance its operations, designed to provide a check on government spending. The negotiations over raising the debt ceiling are often contentious with both parties trying to use the opportunity to advance their own agendas. The current negotiations are no exception.
The debt ceiling has been raised 78 times since 1960. The three most recent major negotiations occurred in 1995, 2011 and 2013, all of which were eventually resolved.
Concerns expressed by investors are related to what happens if negotiations do not result in a resolution, as it could lead to temporary suspension of government services, delay of payments to vendors, government debt or a potential interruption of payment for Social Security or Medicare. The last two are unlikely as the U.S. Department of the Treasury can make payments by other means to avoid a default on debt obligations or key programs like Social Security. A recent editorial in Brookings goes a bit deeper on the contingency plan the Department of the Treasury put in place in 2011 when the country last faced a debt ceiling debate.
It is also worth noting that the flip side of the coin can also occur. If there is an eventual resolution after tense initial negotiations, the reduced uncertainty has the potential to result in a positive effect on investment markets, as it has in the past. The important thing to remember is that the market prices in probabilities of both sides of the coin, and historically, the market has been better at assigning those probabilities than the smartest investors. The proof being that you see a lot fewer successful active investors than you would expect if such anticipation of markets was possible.
At Forum, we take a long-term view. We do not recommend allocation changes around events like debt ceilings because we expect to live through many such events over our lifetime. Reducing stock market exposure across all these events would very likely reduce long-term wealth.
Instead, investors should work with their financial advisor to set up the right mix of stocks and bonds appropriate for their risk tolerance in advance of market volatility. This allows the portfolio to take advantage of market movements through rebalancing and reinvestment of dividends. Forum clients complete Investment Policy Statements for the purpose of having a consistent process and focusing on long-term investing, not short-term market volatility.
An additional discussion worth having with your financial advisor when events like this occur is whether or not to increase your permanent emergency reserves and extended cash reserves. These reserves should be enough to allow you to weather periods of heightened market volatility, as drawdowns happen almost every calendar year, and yet most years are positive in whole.