Last week, the financial markets let out a sigh of relief at the news that Congress had approved a resolution to the fiscal cliff. The stock market rose and faith seemed to have been restored in American politics.
It may surprise you, then, to learn that Congress hardly “solved” the fiscal cliff at all.
As you may recall from our Explanation of the Fiscal Cliff, the fiscal cliff was essentially one part tax policy and one part government spending.
The conclusion to the fiscal cliff did resolve the tax issues, making many of the Bush-era tax cuts permanent tax policy.
However, our elected representatives were unable to reach an agreement on the issue of government spending. Instead of negotiating on spending cuts, they instead kicked the can down the road.
To prevent the automatic spending cuts from taking effect, Congress voted to postpone these spending cuts until March 1st, 2013.
Congress has essentially set up another political showdown over spending. Except this showdown has an additional complication: it will happen at the same time as a debate over whether or not to raise the debt ceiling.
The United States officially hit its debt ceiling on the last day of 2012.
When the government reaches its debt ceiling, the Treasury is legally prevented from borrowing any more money by issuing new government bonds.
The Treasury will continue to pay the government’s bills using “extraordinary measures.” These “extraordinary measures” essentially mean that the Treasury will use money intended for other purposes to pay the government’s more immediate bills. However, even with these measures, the Treasury will only be able to pay the government’s bills for up to two months.
Remember the Previous Debt Ceiling Debate?
The last time the government reached its debt ceiling was on May 16th, 2011. And it took Congress two and one-half months to raise the debt ceiling with the Budget Control Act of 2011.
The deal included spending cuts in exchange for raising the debt ceiling, but these cuts were mostly to take effect in the future. Many regard the deal as merely delaying the inevitable and required spending cuts. Worse, the toxic political climate eroded already low confidence in our political system, and resulted in the lowest-ever approval ratings for Congress.
Just three days after President Obama signed the Budget Control Act of 2011, rating agency Standard & Poors downgraded the credit rating of the United States from AAA to AA+.
In its statement about the credit downgrade, Standard & Poors specifically mentioned the behavior of politicians as key factors in the decision.
“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.”
Of course, the underlying reason for the credit rating cut was the financial well being of the United States government. Between future costs of the major entitlement programs and the massive growth of future interest payments on the national debt, the years ahead look grim. The chart below illustrates how this could unfold in the coming years, even if our government stops spending money on national defense altogether.
S&P’s downgrade of the United States government’s debt was announced late on a Friday. After digesting the news over the weekend, world markets fell sharply when they opened on Monday morning.
This chart shows how the S&P 500 index largely ignored the political stalemate in the weeks before the end of the Treasury’s “extraordinary measures.” Then, as a deal seemed unlikely, the S&P began to fall. The fall accelerated due to credible rumors of an impending credit downgrade. Then, after the downgrade was announced, markets traded significantly lower.
The S&P fell an incredible 6.66% on the trading day after the downgrade was announced.
From July 29th to August 8th, the S&P 500 fell more than 15%. Whether it was the rumors of the downgrade or the presence of political stalemate, one thing is clear: failure to address the debt ceiling and spending problems this time around will almost certainly have negative consequences for the stock market.
Looking Ahead to the Upcoming Debt Ceiling Debate
A new debate over the debt ceiling and government spending is coming, and coming soon. Automatic spending cuts kick in on March 1st and the Treasury will run out of money shortly before then.
The worst-case scenario is that no action is taken on either issue.
Failing to raise the debt ceiling could, theoretically, cause a government shutdown, since the Treasury wouldn’t be able to spend money. Failure to address the scheduled spending cuts would trigger implementation of those cuts. This is something that many politicians on both sides of the aisle agree would hurt the economy, since the cuts are based on percentages and not strategic priorities.
Those would be extreme outcomes and are unlikely.
However, political stalemate is very likely. New credit downgrades could trigger a loss of confidence in the United States’ debt and, as a result, seriously alter the financial landscape.
Since politicians procrastinate and markets can be slow to react to upcoming events, it seems likely that any impact on the markets would be felt beginning in the middle of February.
The Bottom Line
Financial markets around the world jumped on the news of the fiscal cliff deal. However, a new, and potentially more toxic, political showdown will take place over the next two months.
An efficient process and effective outcome seem unlikely to me, as this is not the way our elected representatives have conducted themselves in recent years.
As a long term investor, I try not to pay too much attention to political skirmishes in Washington. After all, the financial health of companies I own stock in is much more important than some debate on Capitol Hill. However, investors should watch this situation as it develops, since a negative outcome would likely drag the whole market lower.
Interested in the current state of financial markets? Read more on Investor Bistro: