Toppling stacks of coins

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Market reaction is the key to swift action on the perennial U.S. debt-ceiling negotiations, says Paul Mielczarski, head of macro strategy at Brandywine Global Investment Management.

Unlike in 2011, he said, investors are remaining patient thus far, so talks are dragging on.

“I’m not that surprised we didn’t get a deal on the weekend. I think in these types of negotiations, both sides really have an incentive to bargain to the last moment to extract maximum concessions,” he said. “And if you look at the financial-market response [to the looming deadline], it’s actually been very benign, which tells you that most investors think we’ll ultimately reach a deal.”

U.S. politicians have until June 1 to agree to raise the upper limit on government spending. If they fail, money will stop flowing from government coffers. The result would almost certainly be market chaos and global economic contraction, Mielczarski said.

But investors aren’t yet pushing the panic button — as they did in 2011, before politicians finally raised the debt ceiling just two days before the deadline.

“Equity markets and other risky assets did sell off very sharply during that period,” he said. “U.S. stocks were down about 15%–20%. And, on top of that, we had a relatively strong rally in bonds [in anticipation of a recession]. Ultimately the debt ceiling was raised, in large part because you had this big financial-market response.”

He said negotiators today need to see a large equity sell-off to get serious about reaching a deal, but investors don’t want to sell stocks if they think a deal will ultimately be reached.

“If we don’t get an equity-market response, does that mean there’s less incentive to reach a compromise solution?” he asked rhetorically.

According to Mielczarski, a complicating factor this year is the Treasury expects to receive large corporate tax revenue payments in mid-June.

“So, you could actually have the unusual situation where the government runs out of money for a week, then you get some extra inflows, and that tides you over, probably until the end of July,” he said. “Nobody wants to sell stocks just to be forced to buy [them] back two weeks later.”

The consequence for the U.S. and world markets would be severe, however, if the Treasury does run out of money.

“This would be a very dangerous situation,” he acknowledged. “What would most likely happen is the U.S. Treasury would try to prioritize payments to bondholders. But that would really require severe spending cuts in other areas like social security and health care, or payments for government contractors. If we actually got to a situation where bond interest payments were missed or social security cheques were delayed, I think there would be a huge reaction, both in financial markets and in public opinion.”

He said he would not rule out an equity market sell-off of 25% or more.

“The U.S. Treasury would suddenly be forced to run a balanced budget. The current U.S. fiscal deficit is about 5.5% of GDP, or US$1.5 trillion. They would have to effectively find a way to cut that to zero. That would clearly be a hugely negative shock for the U.S. economy,” he said. “It’s very likely you would have a U.S. recession in the second half of the year.”

And the damage would not only be at home.

“Given the importance of the U.S. economy, we’re likely to see a significant negative impact on business and consumer confidence around the world,” he said, allowing that impact on world currencies would be mixed.

“I would expect the dollar to sell off quite a lot against the euro, Swiss franc, and the yen, because these countries would generally benefit from a shift in global assets away from the U.S.,” he said. “On the other hand, if you look at currencies like Australian and Canadian dollars [and] some of the large emerging-market currencies, I think they’re more likely to underperform, just because these currencies tend to be closely linked to the global growth cycle and equity-market performance.”

Mielczarski said the debt-ceiling problem is an inevitable feature of the U.S. economy because it was introduced in 1917 as a fixed number, not as a budget percentage.

“As the economy grows, you always end up bumping against this debt limit,” he said.

That bumping is particularly aggressive now, with the U.S. fresh out of an expensive pandemic, infrastructure that needs refreshing, substantial recent tax cuts, a global energy transition and rising interest rates.

“In 2015, the U.S. fiscal deficit was around 2.5% of GDP. Today we are at 5.5%, and that’s likely to increase to around 7% or more by the end of the decade. And that is at a time when the unemployment rate is at historically low levels,” he said. “So, unfortunately, this is not going to be the last big debt-ceiling standoff that investors will face over the next five to 10 years.”


This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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