The US government is set to hit its self-imposed borrowing limit today and both Wall Street and Washington are hoping for a resolution — but preparing for the worst.
The ongoing brinkmanship in Congress over whether or not to allow the federal government to borrow more money to pay its bills is bringing back memories of 2011, when debates over the debt ceiling knocked America's credit rating down a peg first the first time in history and nearly brought the US to default, wounding both the economy and markets.
What's happening: The debt limit, or the amount of money that the federal government is allowed to borrow, was first created in 1917 and has been raised or paused 102 times since World War II.
Now, aggressive tightening by the Federal Reserve and large spending packages have helped bring that ceiling into play once again. But Washington is at an impasse over whether or not to raise the debt limit: The White House expects Congress to pass a debt ceiling increase without conditions while Republicans say that any increase should be accompanied by spending cuts.
That stalemate presents a huge risk to the US economy and the world at large, warned the International Monetary Fund.
The global economy, ravaged by high inflation and interest rates, geopolitical chaos and a potentially widespread recession, does not need another crisis, said Gita Gopinath, the fund's first deputy managing director, at Davos on Wednesday.
"There's already enough uncertainty, there's enough risks that we have to deal with," Gopinath said during a Bloomberg interview. "This shouldn't be an additional risk that the US or the world should have to deal with."
Her warnings follow a stark letter from US Treasury Secretary Janet Yellen this week that said Treasury will take extraordinary measures to continue to fund the government for the next few months.
Wall Street worries: The standoff raises significant risks for investors, the greatest one being that the political stalemate results in the US government defaulting on its debt. If a default were to happen there would be "dramatically negative impacts on a wide range of financial assets including US bonds, equities and the dollar," said David Kelly, chief global strategist at JP Morgan.
The crisis isn't yet imminent, but investors are already preparing for turmoil, wrote David Kostin, chief equity strategist at Goldman Sachs, in a note this week.
Investors may already be hedging their bets and pricing in the impending crisis — the Dow has fallen by 1,000 points over the past two days. The S&P 500 and Nasdaq Composite also dropped significantly.
But without a resolution, steeper declines could be on the horizon. During the last major debt ceiling crisis in 2011, the S&P 500 plunged by 15% and sectors with close revenue ties to US government funding — health care and defense — dropped by 25%.
Companies with the highest revenue exposure to the US government face the most risk, said Kostin. Topping that list is Huntington Ingalls, a defense technology firm, followed by Mercury Systems, an aerospace and defense company. Big names in the health care and defense sectors like Lockheed Martin, CVS Health and Raytheon also have outsized exposure to federal government funds.
What's next: "It should be stressed that it is still quite possible that, after extensive posturing, a compromise will be forged, allowing for some deficit reduction in return for an agreement to raise the debt ceiling," wrote Kelly. But even so, he said, investors should be prepared for a "worse outcome."
Kelly suggests that traders prepare a "debt-ceiling disaster emergency kit" which could include real assets and high-quality international stocks and bonds, denominated in foreign currencies.
Even if disaster is averted, it's not a bad idea to keep the so-called kit on hand, said Kelly. "Given still relatively cheap overseas valuations and the current under-exposure of US investors to overseas assets, these adjustments may well make sense even if Washington doesn't trigger a debt-ceiling disaster," he wrote.
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