Raise the roof

11 mai 2023

The capital dome illuminated after dark in Washington DC.

In recent years, the U.S. federal government’s debt and deficit have been hot topics in the news. The term “debt ceiling” has once again made headlines after Treasury Secretary Janet Yellen warned that the U.S. government could run out of money by June 1. It’s important to understand what the debt ceiling is, why it needs to be raised and how it can impact financial markets.

What is the debt ceiling?

The debt ceiling is the maximum amount the U.S. Treasury can borrow from the public and governmental accounts. Governments, like individuals, must borrow money when they spend more than they earn and they do so by issuing bonds.

The U.S. has had a debt ceiling for over 100 years, first established in 1917 at $11.5 billion. Prior to this, Congress authorized the government to borrow a fixed sum of money for a specified term. After the loans were repaid, the government could not borrow again without asking Congress for approval.

The debt ceiling was created in 1917 under the Second Liberty Bond Act to make it easier to finance WWI. It allowed for a continual rollover of debt without congressional approval. However, increasing government obligations have led to rising government debts to make up the shortfall between tax revenue and government spending.

What are the issues with raising the limit?

To issue more bonds, the U.S. Treasury must increase the debt ceiling. This has been done without incident for decades, with policymakers raising the limit 89 times since 1959. Most recently, in December 2021, the debt ceiling was raised by $2.5 trillion to $31.4 trillion, projected to fund obligations through mid-2023.

US debt ceiling raises keep pace with the growing national debt (in billions of US$)

Sources: U.S. Department of the Treasury, U.S. Office of Management and Budget.

Debates surrounding the debt ceiling have become more contentious in recent years. Disagreement has led to two federal government shutdowns in the late 1990s and a 2011 fight that resulted in volatile financial markets and Standard & Poor’s downgrading of the U.S. government’s credit rating for the first time in history. In addition to political reasons, resistance against raising the debt limit has often come from concerns about the sustainability of the massive government debt balance.

The current public debt outstanding is $31.457 trillion, with each U.S. citizen’s share being around $95,000. Economists and government officials often cite the debt-to-GDP ratio, which measures how much of the annual production would be required to pay off the public debt. The U.S. government’s debt-to-GDP ratio of 148% ranks the fourth highest globally, after Japan, Greece and Italy.

What is the likelihood of the U.S. repaying its debt?

In recent decades, the U.S. government has been in deficit almost every year, except for a surplus between 1998 and 2001. It is projected that the government will continue to run deficits until at least 2028, making it unlikely that the government will be able to repay any debt in the foreseeable future. Instead, more debt will likely be added.

US government surplus of deficit, 1993 – 2028 (dollar amounts in billions)

Source: Congressional Budget Office website.

Until recently, the cost of issuing debt to finance federal operations was minimal. However, with rising interest rates, the average interest rate on federal debt has risen to 2.07% in 2022 from 1.6% in 2021. The Congressional Budget Office estimates that interest costs will triple to $1.3 trillion in 2032, becoming the largest federal budget item and surpassing Social Security and Medicare by the middle of the century.

These developments raise concerns that the world’s largest economy may not be able to meet its financial obligations. As a result, the credit default swap (CDS) against a U.S. government default has risen sharply since the beginning of 2023. On May 4, one-year U.S. government CDS reached 152 basis points (bps), up from 10 bps a year earlier and the highest since the 2008 financial crisis. Although the U.S. has never defaulted on its debt, investors are becoming increasingly anxious about the possibility.

What could happen if the U.S. debt ceiling is not raised?

The U.S. government would be unable to borrow money to finance critical obligations, such as Social Security, tax refunds and federal workers and military salaries. This would result in a severe stock market decline and could damage the reputation of the U.S. as a reliable business partner. Interest rates would skyrocket, potentially causing a U.S. or global recession. The dollar may lose its status as the global reserve currency and drop significantly in value.

While the government could resort to temporary financial measures, such as minting a $1 trillion platinum coin, a more sustainable solution is required to address the gap between revenue and spending. This could involve increasing tax rates, reducing expenditures or both.

The debt issue, combined with the tightening credit cycle following the banking crisis, means that borrowing to fuel growth will become increasingly challenging and expensive. Companies with high leverage may face higher interest burdens.

Evaluating financial health to deliver long-term value

We believe investing in companies with strong financial positions, diversified revenue streams, good profitability and no reliance on government subsidies for growth is essential. We take a disciplined approach to investing and carefully evaluate the financial health of the businesses we invest in. Half of the companies in our International Small Cap strategy and a third in our Global Small Cap strategy are in a net cash position. Our portfolios are well positioned to weather economic uncertainties, with a focus on delivering long-term value to our clients.

Gestion d’actifs Global Alpha Ltée
mai 11th, 2023