Default Averted

What the debt-ceiling increase may mean for investors.

After weeks of wrangling over whether to increase the amount of money that the U.S. government can borrow, the House and Senate have both passed a bill to avoid a default on the federal debt, which could have had far-ranging economic consequences. Markets initially reacted favorably to the news, showing relief that the near-term risk of default had been averted.

The bill resolves the debt issue until the start of 2025 and sets caps on government spending for the next 2 years, except for higher limits on defense spending and increases for inflation.

The bill doesn't raise taxes or touch major programs like Social Security and Medicare. But it would end a 3-year freeze on student-loan payments, cut IRS funding, claw back some unused COVID-19 funding, and expedite large-scale energy and infrastructure projects.

What may be next for markets?

One way the debt-ceiling suspension may affect investors is by enabling the Treasury to rebuild its stockpile of billions of dollars in cash, which is held in the Treasury General Account (TGA). Over the last several months, the U.S. Treasury spent down the TGA, which is a checking account of sorts for the U.S. government. It did this to fund programs and make payments after the debt ceiling was reached in January. Now the Treasury will rebuild the TGA by issuing new debt, which effectively reduces money coming into the banking system. This action combined with the Fed maintaining higher rates and continuing to reduce the size of its balance sheet may produce periods of higher volatility.

Markets generally react over time to changes in the pace of economic growth, and the direction of corporate earnings and asset prices, rather than short-lived political events. However, as the chart below shows, U.S. stocks have historically turned volatile as the government has approached the debt ceiling and then have risen on average in the months following an agreement to raise the debt limit.

In 2011, Congress lifted the debt ceiling but the credit rating agency Standard & Poor's still downgraded the U.S. credit rating to AA+, one step below the best rating of AAA. Standard & Poor's cited the growing deficit and the prolonged debate as reasons for the downgrade. This time, ratings agency Moody's has said it would lower the government's credit rating if it missed an interest payment on its debt in June.

Even after the 2011 downgrade, though, stocks have risen on average after Congress has acted to prevent a government default.

While the specter of a government default has been vanquished for now, the markets still face other sources of uncertainty. "First and foremost," says Director of Global Macro Jurrien Timmer, "is Fed policy. Until recently, the consensus among investors was that the Fed had raised rates for the final time this cycle during its May meeting, and they expected the Fed to soon begin cutting rates."

Many investors had been looking forward to the end of rising rates because higher rates can hurt corporate earnings and stock prices. But with inflation still running well above the Fed's goal of 2%, the central bank may raise rates again.

Why the debt still matters

Raising the debt ceiling is far better than a default, but it does not address the potential impacts of ever-rising government debt. One reason some in Congress opposed lifting the debt ceiling is that the national debt is larger than ever. Publicly held U.S. debt topped 120% of gross domestic product in the third quarter of 2022, according to the U.S. Office of Management and Budget. That's a level of debt far greater than the average over the past 50 years. And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion from 2023 through 2032.

When U.S. debt was downgraded following the 2011 debt-ceiling agreement, one of the reasons ratings agencies gave was the failure of politicians to confront rising debts. Not so long ago, members of both political parties expressed concern about the impacts of government debt and spending. Many Democrats as well as Republicans supported a constitutional amendment requiring a balanced budget and from 1998 to 2001, congressional Republicans and a Democrat president produced balanced federal budgets.

But since then, deficit spending that higher debt makes possible has gained bipartisan support even in a highly polarized political environment. Warns Dirk Hofschire, managing director of research: "Debt in the world's largest economies is fast becoming the most substantial risk in investing today." Fidelity research suggests that higher debt is not a recipe for faster economic growth, and that the responses by policymakers to that debt can ultimately lead to higher inflation and more volatile financial markets than in the past.

Hofschire points out that high government debt is also the result of a number of factors such as the increased demands of an aging population for programs such as Social Security and Medicare.

"Fidelity's Asset Allocation Research Team believes the rise in debt is ultimately unsustainable," he says. "Historically, no country has perpetually increased its debt/GDP ratio. The highest levels of debt ever topped out around 250% of GDP. Since 1900, 18 countries have hit a debt/GDP level of 100%, generally due to the need to pay for fighting world wars or extreme economic downturns such as the Great Depression. After hitting the 100% threshold, 10 countries reduced their debt, 7 increased it, and one kept its level of debt roughly the same."

Hofschire looks to these historical examples to consider what may happen in the U.S. as public debt passes 100% of GDP. He expects political pressures for monetary and fiscal policymakers to take a more active role in the economy will lead to higher inflation in the future. As he puts it, "Government policies are likely to drift toward more inflationary options."

What to consider

A long-term asset allocation plan that includes a mix of stocks, bonds, and cash and that aligns with your goals, time horizon, and your ability to manage risk can help you achieve your financial goals even in an environment of higher inflation.

Investors concerned about the prospect of higher inflation in the future may want to consider further diversifying their portfolios by adding exposure to asset classes that have historically benefited from higher inflation.

If you want to create a plan with inflation in mind or want to refine your existing plan, try our online tools in the Planning & Guidance Center. Or for professional help, consider a Fidelity planning consultant.

What can investors do about the debt?

There will always be times of uncertainty so it's important to take a long-term view of your investments and review them regularly to make sure they line up with your time frame for investing, risk tolerance, and financial situation. Ideally, your investment mix is one that offers the potential to meet your goals while also letting you rest easy at night.