Debt ceiling showdown

RYAN   By Guest Blogger Ryan Lewenza

Here we go again. The US government has hit its debt ceiling limit, which is the legal limit of national debt that the government can accrue. Once this level is breached the US Congress needs to vote to increase the debt limit so as to avoid defaulting on the debt. Since 1960, the US Congress has voted to increase the limit 78 different times so this increase will make it lucky 79.

The issue is that with the Republicans taking back the House and a hard-right faction of the Republican Party – the House Freedom Caucus – gaining incredible control in the party (there’s roughly 30 of them which is meaningful given the Republicans narrow majority), they’re setting up for a fight and may use the debt ceiling as leverage to force the Democrats to agree to major spending cuts, something the Dems have been very reluctant to do. So, in the coming months we’re going to see a political version of Gunfight at the O.K. Corral, with big implications for the US economy and markets.

Today I’m going to review how the US got into this predicament, how I believe US politicians should deal with the out-of-control deficits and debt, and my take on how this may play out in the coming months.

The US Treasury officially breached its debt limit of $31.4 trillion last Thursday, forcing the US Treasury to start taking ‘extraordinary measures’. Essentially, the Treasury is just re-arranging deck chairs by delaying certain payments and buying time. This includes things like redeeming certain investments and suspending new investments into different government funds.

By implementing these measures the US government is able to kick the can down the road for a bit, which based on comments from the Treasury will get them till June. At this point, Congress has to act, which if the Republicans play hard ball like they did in 2011 and 2013, we could see some fireworks again. Cooler heads will ultimately prevail in the end but nothing surprises me these days coming out of Washington.

U.S. Government Debt at a Jaw-Dropping $31 Trillion

Source: Bloomberg, Turner Investments

But let’s back up and review how we got here.

There’s often a misconception that the debt is largely due to overspending (partially true) on government programs by the Democrats and that Republicans are much more fiscally prudent and deficit focused. That data does not support this.

Doing a simple analysis by adding up the deficits and contributions to the debt under the different presidents shows that it’s about a wash. More recently, under years of Republican presidents (Bush and Trump) the debt rose by $12.7 trillion and under Obama and Biden the debt rose $13 trillion.

Think about that for a minute. Since 2002, when Bush took over from Clinton, the US debt has exploded from $6 trillion to $36 trillion or a 6x increase. How did this happen?

The Republicans added to the deficits and debt through their aggressive tax cuts (Bush in 2003 and Trump in 2017), wars (one estimate has the cost of the Iraq and Afghanistan wars at $1.6 trillion) and increased spending, particularly on defense. Last year, for example, the US government spent $800 billion on defense, which is more than the next 9 largest countries combined spending on defense!

Tax cuts are often sold on the premise that they will ‘pay for themselves’, also known as ‘trickle down’ economics. But outside of a quick boost to the economy, this often doesn’t materialize and then the government is left with a lower tax base to fund all the spending.

But Democrats are no better. Biden announced a third Covid stimulus plan of $1.9 trillion (Trump already did two to the tune of $3 trillion) and Obama rolled out an $800 billion package to deal with the fallout from the financial crisis. This is on top of all the other spending and programs they rolled out. I recognize there were some huge disruptive events like the pandemic, which required a large government response, but it was way too much and this trend of higher government spending has been going on for decades.

The chart below calculates the percentage of US government spending as a percentage of the overall US economy and it has been steadily rising. There’s just too much government spending and this chart speaks to that.

US Government Spending as a % of GDP

Source: Trading Economics

We need to be honest. Both parties contributed to this mess and it’s going to require an ‘all hands on deck’ plan to deal with these deficits and surging debt levels. The Democrats don’t want to talk about entitlement reform (e.g. Social Security) and the Republicans refuse to consider tax cuts. Get over it already. If you want to really start dealing with the debt it’s going to require bipartisanship and compromise, rare traits these days in politics.

In my view, it’s going to take addressing all three of the pillars – cutting government spending, entitlement reform and raising taxes – to rein in the deficits and return to a surplus so the US can actually start paying off some of the debt.

Last year the US government spent $6.27 trillion so if they were to cut say 10% across the board that would represent $627 billion of cuts, which is less than half of what the US deficit was in 2022 ($1.37 trillion). Cutting spending will not be enough, which is why I believe the US needs to consider reasonable tax increases as well. Finally, both Social Security and Medicare will need to be reformed as boomers continue to age and these programs are only fully funded for so many years. This is why I believe all options need to be on the table and that the pain will have to be shared.

Back to the looming debt ceiling, as we saw from those depressing votes to elect Kevin McCarthy as Speak of the House, the Republicans have a very narrow majority (could get even narrower if Santos steps down) and given this the Freedom House Caucus is going to try to get their ‘pound of flesh’ and force the Dems to cut spending. While I don’t agree with their tactics I do agree with their current stance (many of them were fine when Trump was spending gobs of money) that addressing the spending and deficits needs to be a priority.

So we’re likely going to see some headlines and potentially some market volatility around the spring as we get closer to the date that the US Treasury runs out of cash. But like the other 78 times they will get a deal done even if in the 11th hour since the alternative (default) is just not an option.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.


The head vs the brain

   By Guest Blogger Tatiana Enhorning

The brain is a powerful organ and no matter how hard we try, it can sometimes overpower our rational mind. Behavioral Finance investor psychology is a fascinating space which acknowledges investors have limits to their self-control and are influenced by their emotions, assumptions and perceptions. These biased and irrational behaviors have real costs. In fact, a study by DALBAR, a financial research firm, has shown that the average do-it-yourself equity investor earned an average annual return of 4.25% in the 20 years between 2000 and 2019, while the S&P 500 added 6.06%.

We often think the world of investing is purely rational and logic-based and with the proper information, we can make the correct decision every time. But try as we might, our past experience and unique brain wiring can often skew vision. Last year you may have noticed your most irrational investing fears and biases rear their ugly heads. Getting to know your brain’s unique wiring and your own personal biases can help you recognize and circumvent these tendencies before they affect investments.

One way of doing this is to get to know what type of investor you are.

Are you an idealist, or a pragmatist?

Firstly, do you fall into more of the “Idealist” or “Pragmatist” category? Idealists are seemingly eternally optimistic about the stock market and tend to seek information that validates this viewpoint. They may overestimate their abilities and underestimate the abilities of others and, therefore, not always do much research before investing. The idealist may read some articles and seek one or two reputable opinions, but really they are susceptible to investing fads. If you’ve bought into the crypto hype over the past few years, then you may fall into this category. Idealists tend to be vulnerable to overconfidence bias, availability bias, self-attribution bias, recency bias and illusion of control bias.

Pragmatists on the other hand do much more in-depth research and know their abilities and limitations. They tend to demonstrate a healthy dose of skepticism about their own investing knowledge and abilities. Pragmatists know that the markets may very well be operating at a more complex level of probabilities which simply may not fall into their field of expertise. Because of this they are also likely to seek out views that are contrary to their initial belief about an investment and then weigh those opinions accordingly.

The difference between framers and integrators

Secondly, are you a “Framer” or an “Integrator”? Investors who are framers tend to view their investments on an individual basis rather than how they fit into the overall portfolio plan. They tend to be very rigid in their approach to analyzing problems and may have different “pots” of money that aren’t really working together: one for long-term savings, one for a down-payment on a new house and one for an upcoming vacation. This is not necessarily a bad thing but framers may very likely have inefficient investment overlap causing concentration risk or drag on performance. They are subject to anchoring bias, which causes them to get stuck on a particular price (such as their own purchase price), or to cling to arbitrary purchase ‘points’, which can lead to biased future calculations. Framers tend to be susceptible to framing bias, conservatism and ambiguity aversion.

The following statements are typical of framers: “My portfolio matched the index this year, but I’m really disappointed with how ABC Company performed. If I didn’t invest in it to begin with, I would have beaten the market by 3 points!”

Whereas the integrator would say, “That ABC stock which performed poorly may end up performing well when the overall market suddenly turns negative.” If you are a fan of this blog and agree with its views on overall portfolio balance and diversification, you likely fall closer to the Integrator profile. Integrators are able to view the broader context. All the investments in all their portfolios are one big integrated system working together in a harmonious ecosystem where every security has a part to play. Integrators tend to understand the correlations between their various financial instruments and structure their portfolio accordingly, with a more flexible approach to market and security price levels.

How reflectors rationalize and realists accept

Lastly, which of the “Reflector” versus “Realist” types best describes you? Reflectors tend to justify and rationalize poor investment decisions instead of taking action to rectify them. They tend to hold on to hope that their fortunes will turn around. They also fear making mistakes and may hold onto securities even when they see they are not a good fit for their overall portfolio. Reflectors often suffer from decision paralysis as they dread the regret of a miscalculation. For example, reflectors may hold onto inherited securities out of sense of loyalty to a deceased relative, even though they are not a good fit for their overall portfolio or market environment. Reflectors may be susceptible to loss aversion bias, endowment bias, regret aversion, status quo bias and hindsight bias.

Realists, on the other hand, do not have trouble coming to terms with the consequences of their investing choices. Once they see they made a mistake, they are quick to admit it and rectify it before the situation gets any worse. Because realists have an easier time making decisions under pressure, they do not experience regret as acutely, and consequently do not dread them ahead of time.

Even smart investors need advice. If you find that you fall into any or all of the first types in each of the three buckets (Idealist, Framer and/or Reflector), a professional financial advisor can be especially advantageous to help you stay on track. If we can notice and get past our most common biases, we can ensure the illogical brain does not foil well-reasoned investment plans.

And if you don’t think you have any biases, then you may have succumbed to superiority bias.

Tatiana Enhorning is a Financial Advisor with Turner Investments. She builds and maintains portfolios for clients across Canada, and has been in the business as an asset manager for more than a decade.