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The debt ceiling is back: Now what?

Our experts say to expect another debate as we approach the debt limit in the fall.

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The U.S. debt ceiling, which was temporarily suspended earlier this year, has come back to life. Congress and the president will have to act by the fall in order for the government to keep borrowing to pay its bills.

Will lawmakers act ahead of time to raise the debt limit? Or will each side dig in its heels and push the debate to the 11th hour, roiling the markets in the process?

We checked in with Fidelity political and market experts to get their take on the outlook for the debt ceiling debate and what it could mean for investors.

There was a big sigh of relief when lawmakers addressed the fiscal cliff at the last minute. But the deal they reached left several fiscal issues on the table. In the first quarter of this year alone we had to deal with the budget sequester, the debt limit, and the expiration of government funding. There was some concern that political gridlock on one—or all—of these issues could have created some volatility.

To the surprise of many, fiscal debates didn’t cause much turmoil early this year. Congress let the budget sequester take effect—which was largely expected—and passed laws to help ease the implementation of the some of the spending cuts. They also passed legislation on a bipartisan basis to temporarily deal with the debt limit and government funding. The good news is that we avoided short-term turmoil. But these issues have not been resolved. The sequester is still in effect, and debates over the debt limit and government funding have simply been delayed until the fall. In my opinion, the debt limit debate has the potential to be the most consequential fiscal debate this year.

The debt limit was resurrected on May 19. However, Treasury has said we won’t reach the debt limit until September at the earliest. Some analysts believe the deadline will be sometime in October. But if Congress and the president don’t eventually raise the debt ceiling, Treasury won’t be able to borrow additional funds to pay all of the government’s bills.

I believe the debt limit will ultimately be addressed. The question is, will lawmakers deal with it quickly and easily—like they did in January—so that investors barely notice, or will the debate go to the 11th hour and create market volatility, like it did in the summer of 2011?

We’re not sure, but a lot of people in Washington are bracing for a debate that goes down to the wire again. House Republicans recently passed a bill that would allow Treasury to keep making principal and interest payments on our outstanding debt so that we don’t default on the debt if the limit is reached. This bill is unlikely to pass the Democratic-controlled Senate, but it suggests that House Republicans are at least preparing for the possibility of a contentious debate. 

It’s hard to predict how the debate will unfold, because neither side has staked out a public position yet. However, the White House continues to say the president won’t negotiate over the debt limit—in other words, he wants the limit raised without any strings attached. But Republicans are likely to ask for at least some spending restraints. Many would like to see changes to contain the growth of entitlement spending—an ask that will be met with stiff opposition from most Democrats. Some Republicans would also like to see a fast-track process for tax reform in exchange for raising the debt limit. But it’s still too early to read the tea leaves on this debate.

Just as the debt ceiling suspension expired, some surprisingly positive news emerged that could put off the date on when Treasury’s ability to borrow ends. The first quarter of 2013 has seen a surge in tax receipts stemming from both withheld and nonwithheld taxes, and a gradually improving economy, which could actually add up to better than expected revenues. Moreover, fiscal restraint imposed by the sequestration has had less of an impact on the broader economy. Both of these factors have led to lower than expected borrowing needs this year. In fact, the U.S. Treasury expects to pay down $35 billion in net marketable interest between April 2013 and June 2013. In addition, the Treasury also signaled that it may reduce the size of some of its Treasury securities. Both of these will likely delay the date at which the debt ceiling is reached and, I believe, could prevent any negative ratings actions in 2013. That said, this current improved fiscal deficit picture, may potentially give Congress less impetus to focus on longer-term fiscal issues.

As we expected, the economy has been weathering the fiscal austerity from the sequestration cuts relatively well. Growth is slower than it would have been without the spending cuts, but the drag has been manageable due to the underlying momentum in the economy.

The positive news on the fiscal front is that the government budget deficit has been declining at a pace much faster than expected. The Congressional Budget Office projects the fiscal deficit to fall to 4% of GDP in 2013, down from 10% in 2009. Economic growth, along with additional revenues from the tax increases that went into effect early in the year, has contributed to this progress. This doesn’t mean the U.S. is out of the woods. While deficits are projected to fall further, the long-term budget outlook remains unsustainable, largely due to rising medical expenses associated with entitlements for the retiring baby boom generation.

But for now, the broad trend is positive. Despite the messy, noisy, dysfunctional debates, the results have added up to more than $2.6 trillion in budget savings from spending cuts and revenue increases. It is possible a debate around the debt ceiling in the fall could be unsettling but, given this progress, the fiscal deadlines are less of a crisis issue and have become less potent in their ability to drive the markets by themselves.

Meanwhile, the U.S. economy continues to incrementally improve. On the consumer side, we continue to see net job creation. The housing recovery keeps gaining traction and contributing even more to the real economy. Corporations have strong balance sheets and cash flows, and they’re returning more money to shareholders in the form of share buybacks and dividend payouts. We have a very stimulative Federal Reserve, and pretty low inflation.

These are good tailwinds for the market. We’ve had a strong rally recently in most riskier asset categories, so asset valuations now reflect more of this outlook than they did several months ago. Anything can happen in the near term after a big rally like this one, but conditions are generally favorable for a well-diversified portfolio that includes appropriate exposure to U.S. equities.

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