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Debt Ceiling Debate Is A Big Story With Little News

The President interrupted “The Bachelorette” last week to discuss the debt ceiling. This must be serious. The will-they, won’t-they tug-of-war in Washington has made everyone nervous – taxpayers, the media, and unmarried beauties alike.

Amid all this discussion, one crucial point is being overlooked: What happens to the debt ceiling doesn’t really matter to the larger economy.

No new information about the United States’ financial status has come to light in this debate. Whether the debt ceiling is raised by tomorrow or the government makes alternative payment plans for near-term obligations, the market already knows that the U.S. owes more than $14 trillion. The market also knows we will owe more in the future, considering the burden of Medicare and Social Security programs combined with an aging baby boomer population. There are no surprises here.

As Larry Elkin pointed out in his column two weeks ago, credit agencies should be more concerned with our ever-growing debt than with the bills for August 2011, and raising the debt ceiling now is still no guarantee against a credit downgrade (which seems to be what the president is most worried about anyway). If and when the U.S. Treasury’s credit rating drops, it will be a reflection of confidence that has already been lost, not a bolt from the blue.

This is not to say there will be no market reaction if Congress doesn’t raise the debt ceiling, or if our credit rating changes. But if investors sell off in massive amounts, it will be an emotional, irrational reaction rather than a reasonable response.

Still, the debates have resulted in some new information that should bear on investors’ decisions. Instead of worrying about the debt ceiling itself, we should consider that the latest debt deal authorizes fiscal austerity to the tune of $2.4 trillion. Whatever deal is eventually accepted will almost certainly reduce government spending substantially over the next decade.

This would be no small matter for the economy as a whole. U.S. government spending ran about 24 percent of the country’s GDP in 2010. Sudden austerity measures will pressure the economy in the near term, especially as we slowly recover from a recession in which government spending picked up a great deal of slack from consumers and businesses that were unable or unwilling to spend themselves. The fact that government spending cuts are likely to hamper the economy is the main event; the debt ceiling discussions and the risk of credit rating downgrade are really just the sideshow.

Such spending cuts will certainly mean slower growth in the U.S., at a time when other developed economies in Western Europe and Japan are no shining economic stars either.

While reacting emotionally to the potential debt ceiling crisis isn’t smart, that does not mean investors shouldn’t take action. The consequences of the U.S. present and future debt obligations will arrive sooner or later, and it pays to be prepared. For several years now, equity portfolios of Palisades Hudson clients have been positioned for slower U.S. growth. We believe it makes sense to invest in companies that are increasing their revenue from developing economies and fiscally sound countries. These include U.S. multinationals that are growing overseas, as well as regional plays in China, India, Latin America, Canada and Australia.

It’s also important to remember that when and if the credit rating for U.S. Treasury debt is downgraded, regardless of what happens to the debt ceiling, interest rates will rise. Long-dated U.S. Treasury debt seems like a bad investment in these circumstances. Instead, consider AAA-rated corporate debt. Companies like Exxon, Microsoft, and Johnson & Johnson stand to benefit from a U.S.’ credit downgrade, as they would then be more secure than the Treasury, according to the ratings agencies.

Though there is much discussion about what will happen if the debt ceiling does not rise, the United States will almost certainly never truly default. Before that could happen, the Federal Reserve would simply print more money. Doing so, however, would cause significant inflation, and would serve as one more reason to invest in companies that do not earn their revenue in dollars.

Federal Reserve Chairman Ben Bernanke urged policymakers to avoid a cut in the national credit rating in a speech last month. If credit ratings dropped, he said, “Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period.”

So the debt ceiling may rise by tomorrow, or it may not. We should not assume anything will happen in Washington until it actually does. Regardless, the U.S. government has too much debt, and this is not new information. Keeping calm and planning for the long term will keep investors from falling into a media-fueled panic over circumstances which shouldn’t take anyone by surprise.

If you enjoyed this article, be sure to check out Palisades Hudson’s book, Looking Ahead: Life, Family, Wealth and Business After 55, now available in paperback and as an e-book.

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