Special Market Commentary: July 20, 2011

The U.S. Debt Ceiling & Deficit Reduction Plan: Precarious Politicking

Executive Summary

• Details are still sketchy, but the tenor in Washington has quietly shifted toward serious negotiations to reach an accord to raise the Federal debt ceiling.
• Leaders in both parties recognize the severity of not raising the debt ceiling; while there are clear philosophical differences between – and even within – the two parties about how best to reduce projected deficits, we believe that sufficient bi-partisan support is coalescing in both Houses that a compromise bill will be reached before the August 2 deadline.
• The possibility still exists that temporary setbacks in negotiations could contribute to market volatility. Investors should be prepared for that possibility, but recognize that attempting to time the markets in reaction to the daily flow of news is treacherous.
• Even if a deal is reached, the wild card is the possibility that one or more of the major bond rating agencies could still decide to downgrade the U.S. Government’s current AAA-rating.
• The need to raise the debt ceiling is clearly the urgent issue; substantive changes will still be needed in the years ahead to adequately address the nation’s structural deficits. The bills under consideration right now are the first step in what will need to be a long, challenging national dialogue about tax policy, federal spending, and, ultimately, the role of the Federal Government in the decades ahead.

The United States is now less than two weeks away from the August 2 deadline for the passage of a bill to raise the Federal debt ceiling. Missing this deadline increases the risk of a default and the potential for the U.S. Government to be stripped of its AAA debt rating by one or more of the major credit ratings agencies. The politicking, posturing, and finger-pointing in Washington has become more heated in recent weeks, and fears have been rising that the process could break down. While the final outcome is still far from clear, developments in recent days point to progress that reinforces our view that a deal will likely be reached in time.

We say “likely” because we believe that most policymakers on both sides of the aisle recognize the need to avoid a default, even if that means signing on to a bill that doesn’t necessarily fit with their personal preferences or those of their constituents. Nonetheless, we are also reminded of the breakdown that occurred in September 2008, as the House of Representatives initially voted down the TARP bill. Ultimately, TARP was passed by both houses and signed by President Bush, but not before a violently negative reaction by the market. Thus, we acknowledge the relatively recent precedent for political wrangling and ideology to temporarily derail the process, even if the anticipated outcome ultimately comes to pass.

Given the impending deadline, developments have accelerated in recent days. Even as we write this, we recognize that the shifting sands in Washington could take the legislative process in a different direction. At present, it appears that the parties involved have sketched out a series of bills and votes that are in part driven by the need to get something done, and in part a perceived need to be “on the record” as voting for a bill that addresses campaign promises and ideological beliefs. While the bill that was approved by the House of Representatives on Tuesday evening appears to have no realistic chance of being passed by the Senate (or signed by the President), it satisfies the need of House Republicans to push forward a plan that raises the debt limit, reintroduces a balanced budget amendment, cuts future spending and avoids any tax increases. It would also force the Senate and President to have to address the bill specifically and go on the record as opposing it, providing additional political ammunition for the upcoming 2012 elections.

Simultaneously, a bipartisan group of Senators (the so-called “gang of six”) appears poised to unveil a proposal that would raise the debt ceiling, cut spending, institute some tax reforms, and cuts the projected deficit by as much as $3.7 billion over the next 10 years. President Obama has voiced his support for that proposal. Separately, Democratic Majority Leader Harry Reid and Senate Minority Leader Mitch McConnell have been working on a fallback deal, the details of which are still taking shape. Yesterday, Senator Reid indicated that some elements of the proposal by the “gang of six” Senators may be incorporated into the final bill that would go to the Senate, although Senator McConnell has been more measured in his public comments on the plan, likely due to the revenue-related provisions. Ultimately, the scope and terms of the “gang of six” plan may prove to be too controversial to garner sufficient bipartisan support in the required timeframe. As such, the final bill that comes before the Senate may more closely resemble the Reid-McConnell fallback plan that does not cut as deeply but allows for the debt ceiling to be raised before the August 2 deadline.

While the scope and scale of the legislation is being debated, there appears to be sufficient support on both sides of the Senate aisle to reach an agreement to raise the debt ceiling in the required timeframe. It appears highly unlikely that disagreement over the specific terms will be severe enough to scuttle the passage of a bill that accomplishes that goal. At that point, we believe that the bill may encounter some resistance in the House, but would successfully pass the House and secure the President’s signature before the August 2 deadline.

What does this mean for the economy and for investors?

• As we’ve noted in prior commentaries, we still anticipate that a deal will be reached. While the specifics are yet to be ironed out, it appears that the leadership of both parties recognizes the gravity of the situation and will act accordingly. Certainly, there is always the risk that discussions could break down and the August 2 deadline will be missed, but we still view that as a low probability outcome.
• While the rhetoric seems to have been ratcheted back in recent days as party leaders move closer to a deal, the potential for further posturing and finger-pointing in the next few weeks still exists. If the tides turn and the parties are unable to reach an accord soon, a negative market reaction would be likely. An increase in volatility could be short-lived as developments could shift direction quickly. Needless to say, attempting to time the market on this issue is treacherous.
• While the details of any bill to raise the debt ceiling are still evolving, there is still a need for policymakers to demonstrate a serious effort in addressing the longer-term budget deficits. Given the tight timeframe, it would be impossible to reach any substantive deal on that issue.

In their July 14 announcement putting the credit rating of the U.S. Government under review, Moody’s Investor Services noted that the outlook for the rating on United States debt may be downgraded to negative unless, “substantial and credible agreement is achieved on a budget that includes long-term deficit reduction.” In addition to issuing a similar warning and assigning a negative outlook, Standard & Poor’s stated that if a credible deficit reduction plan is not achieved within the next 90 days, it would take the next step and lower the United States’ credit rating.

That may still be the wild card for investors. The short-term need to strike a deal to raise the debt ceiling is the urgent issue. That deal is also likely to take some initial steps toward reining in future budget deficits at the margins. However, these initial steps are highly unlikely to go far enough to materially alter the long-term, structural deficits or the trajectory of the nation’s debt. Neither Moody’s nor S&P indicated what steps they would deem sufficient to sustain their current ratings for U.S. Government debt, but the risk of a downgrade at some point still exists even if the debt ceiling is lifted. Their warning was a shot across the bow of policymakers in Washington, and should not be taken lightly.

In summary, we believe there is a high likelihood that a deal will be reached and the potential near-term default will be avoided. While the bills under consideration will take some initial steps toward reducing the projected Federal deficits in the years ahead, it is not going to represent a definitive long-term solution. Policymakers will still need to substantively address the nation’s structural deficits in the months and years ahead, a process that will require some very difficult decisions related to both the revenue and expenditure sides of the equation.

Politicians are acutely aware of the election cycle, making it easier to try to push those decisions down the road. Nonetheless, most recognize that the current level of deficit-spending is not sustainable. The sharpened global focus on more disciplined fiscal policy, particularly given the severity of the challenges in Europe, appears likely to keep heat on Washington for some time. We anticipate that a more challenging national dialogue about tax policy, federal spending, and the role of the Federal Government still lies ahead, even after the immediate issues are resolved.


The information provided in this update is based on information believed to be reliable at the time it was issued. Any analysis non-factual in nature constitutes only current opinions, which are subject to change.