Potential U.S. debt default: Why to stay the course

Markets are bracing for two near-term challenges related to U.S. government funding. Investors can be sure of one thing: We’re in for a period of heightened, enveloping uncertainty.

The immediate challenge is the potential for a government shutdown. That happens—frequently around the October 1 start of the fiscal year—when Congress hasn’t authorized the approximately one-third of U.S. spending classified as discretionary. Absent a resolution to temporarily authorize spending, parts of the government will be shut down. It’s never pleasant, especially for workers directly affected through the loss of a paycheck. But investors, the markets, and the economy have endured shutdowns before, and no doubt can do so again.

A second and potentially greater challenge could materialize around October 18 when, the Treasury Department has warned Congress, the government will no longer be able to pay all its bills unless the $28.5 trillion statutory debt ceiling is increased or suspended.

Increases to the debt ceiling aren’t new either. They’ve occurred dozens of times over the last century, mostly matter-of-factly, a tacit acknowledgement that the bills in question are for spending that Congress has already approved. Episodes in 2011 and 2013, however, were more contentious, leading a major ratings agency to downgrade U.S. debt in the 2011 instance. Failure to address the current challenge could shake global markets even before the Treasury has exhausted its available measures to pay bills.

A potential government shutdown: 21 and counting

A government shutdown would be the 22^nd in 45 years. One was resolved within hours. The last one, in 2018–2019, was the longest on record, at 35 days. Interestingly, the Standard & Poor’s 500 Index has gained ground more times than it has lost during government shutdowns. And investors who have stayed the course have benefited from the market’s penchant to rise over the long term. A greater risk may be that investors give in to the cloud of uncertainty, abandon a well-considered investment plan amid volatility, and lock in losses or miss out on gains.

Effects on the economy, meanwhile, typically are related to the duration of a shutdown. The 2018–2019 partial shutdown shaved $3 billion, or 0.02%, off U.S. GDP, after accounting for forgone activity later recouped.¹

A potential U.S. debt default: Tarnishing a stellar credit history

A U.S. debt default, meanwhile, whether through delayed payments on interest owed on U.S. Treasuries or—more likely—on other obligations, would be unprecedented. Its broadest but not intangible effect would be one of perception. We don’t doubt for a second the ability of the United States to pay for its obligations. Vanguard’s assessment of the minimal credit risk posed by the United States is supported by its strong economic fundamentals, excellent market access and financing flexibility, favorable long-term prospects, and the dollar’s status as a global reserve currency.

But perception is tied to the reality that someone isn’t going to be paid on time, whether it be government contractors, individuals who receive entitlement payments, or someone else. The damage to U.S. credibility would be irreversible. Even if a default were only technical—if payments other than interest on debt were delayed—the United States could no longer fully reap the benefits bestowed on the most reliable debtors.

Interest rates would likely rise, as would financing costs for businesses and individuals. Debt ratings would be at risk. The government’s own financing costs, borne by taxpayers, would increase. Stock markets would likely be pressured as higher rates made companies’ future cash flows less predictable. Such developments occurring while economic recovery from the COVID-19 pandemic remains incomplete makes the potential scenario all the more important to avoid.

Staying the course continues to matter

Vanguard is well-prepared from an operational standpoint in the event that a default can’t be averted. We’ve taken measures to mitigate risk across the business. The course of events will depend in large part on how long any impasse may endure.

Markets, meanwhile, may turn quickly, in either direction, and with each new development. They’re forward-looking and don’t like uncertainty, and that combination can result in sharp, sudden swings. Despite the uncertainty—but really, because of it—we continue to recommend that investors be guided by Vanguard’s Principles for Investing Success, particularly to have the discipline to focus on a long-term plan even during periods of short-term upheaval.

We don’t believe, despite the degree of opposing views, that policymakers will allow a debt default to occur. The stakes are too high. We hope that resolution doesn’t occur so late in the process that it inflicts lasting damage on the U.S. economy.

Stay the course. It’s what successful Vanguard investors have done for decades.

¹ Congressional Budget Office, January 2019.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Past performance does not guarantee future results.

While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

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