First and foremost, our thoughts are with the thousands of people who have been affected by the devastating wildfires in Alberta. On the investment side, the U.S. debt ceiling has been front and centre. While it hasn’t resulted in significant volatility beyond certain segments of the U.S. government bond market, it remains a near-term risk demanding swift resolution. Our bigger concern is that the U.S. is on a path of ever-higher debt and deficits, raising questions about the sustainability of its financial standing.

The self-imposed U.S. debt ceiling, established in 1917, sets a legally defined limit on how much the U.S. government can borrow to pay its bills. This limit has been reached and raised over one hundred times. The debt ceiling often makes its way into the news when passing the required legislation is expected to be more difficult, typically when there is a divided government. This is the case today, with Congress divided between the Republicans who control the House of Representatives and the Democrats who control the Senate. The Republicans are citing a need for budget renegotiation before considering any increase to the debt limit. Meanwhile, the Democrats began negotiations with a firm “No” on any budget concessions, but there have been some signs of potential compromise and progress in recent days. The debt limit was technically reached earlier this year, but extraordinary measures have pushed the hard deadline to early June, according to Treasury Department estimates.

We believe the likelihood of failing to reach a deal and consequently defaulting on the debt is relatively small. However, it is worth remembering the potential cost of the path to an agreement. During the last major standoff in 2011, the negotiations between the Democrats and Republicans ran so close to the deadline that the U.S. credit rating was downgraded for the first time in the country’s history by Standard and Poor’s.  

The focus on the debt ceiling has revived some of our longer-term concerns about U.S fiscal health. More specifically, U.S. debt continues to grow due to spending that far outpaces its revenue – a situation called a deficit. The Congressional Budget Office estimates that the country’s deficit will nearly double over the next decade, increasing from $1.5 trillion to $2.9 trillion.

The U.S. is facing a dilemma similar to that of other countries. It has options to improve its deficit position, but little political will to do so. Among the possible solutions are tax hikes, its main source of revenue. But the bigger opportunity lies with its expenditures, which tend to fall into three categories: interest payments on outstanding debts, discretionary spending in areas like defense and education, and spending on programs such as Social Security and Medicare. Given an ageing population, the U.S.’s future commitments to these entitlement programs are projected to rise meaningfully unless structural changes are made. Unfortunately, comments from both the Democratic and Republican parties suggest entitlement reform is off the table. In other words, few political leaders are willing to tackle the root cause of the country’s deficit and debt challenges.

We expect the debt ceiling issue to be resolved one way or another over the days and weeks to come. Though it may come down to the wire, as it has many times before. We don’t expect our longer-term concern to be addressed any time soon. While it’s unlikely to have significant implications for portfolios over the next few years, it’s an issue we remain mindful of given the implications on the country’s credit rating, the role of the U.S. dollar, the competitiveness of the country, and its long-term economic trajectory. Those considerations may influence our asset allocation and portfolio positioning over time.

Should you have any questions, please feel free to reach out.

 

 

Beth Arseneau, FMA, CIM
Investment Advisor
416-960-4592
beth.arseneau@rbc.com