Congressional Republicans and Democrats are clashing ahead of a series of deadlines that Senate Senate Minority Leader Mitch McConnell (R-KY) arrives to speak at a press conference on the debt limit on Capitol Hill in Washington, DC on September 22, 2021.
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The scramble over the debt ceiling, government funding, and President Biden’s spending plans has been overlooked as investors have been focused on tapering and tightening clues from the Federal Reserve. The situation in Washington, meanwhile, has gotten messier and warrants attention.
Political risks to the market have been increasing in recent weeks and may ratchet up further in the coming days, says Brian Gardner, chief Washington policy strategist at Stifel, in a note to clients Wednesday. “The prospects of a default or the collapse of the infrastructure bills remain low probabilities, but these outcomes can no longer be easily dismissed or discounted,” he says.
Intraparty fighting on the left and typical political posturing between Democrats and Republicans mean the debt ceiling, spending plans, and government funding bills are inextricably linked and together resemble a multilevel game of chicken.
Risks include a possible government shutdown, the showdown over raising the debt ceiling, and the potential collapse of Democrats’ plans to pass two spending bills. One of those bills is the $1.2 trillion “hard” infrastructure plan that has already passed the Senate with bipartisan support. The other is the $3.5 trillion “soft” infrastructure bill—the capstone of Biden’s economic agenda and a sweeping plan to significantly expand the nation’s social safety net, cut carbon emissions, and raise taxes on corporations and some households.
Republicans say they won’t vote to lift the debt ceiling, hoping to make Democrats shoulder the move that is necessary for the U.S. to continue to meet its financial obligations. They say Democrats should include the debt ceiling increase in their $3.5 trillion spending package. That bill is going through the reconciliation process meant to fast-track spending and tax legislation and requires only a simple majority, but Democrats don’t want to have to raise the debt ceiling alone. They point to significant emergency spending during the Trump administration and are wary of the political edge such a move would hand Republicans heading into midterms as that party hammers the left on hefty spending and rising inflation.
“There could be a moment in the coming week or two when it looks like the whole process could collapse.”
Democrats want to address government funding and the debt limit simultaneously. As Gardner notes, they added hurricane relief aid as a sweetener to attract Republican support but on Tuesday, every House Republican—including the Louisiana delegation—voted against a so-called continuing resolution that would fund the government until December 2021, suspend the debt ceiling until December 2022, and provide hurricane relief. That means there is virtually no chance the CR, which passed the House on a strictly party-line vote, will pass the Senate. After Senate Republicans block that bill, Democrats could pivot and offer a “clean” CR to keep the government open after Sept. 30, but the chances of a government shutdown on Oct. 1 have risen and are now slightly above 50/50, Gardner says.
A poll out Wednesday morning gives investors some reason to believe Democrats will ultimately attach the debt ceiling to the $3.5 trillion reconciliation bill. A Politico/Morning Consult poll found that more voters would blame Democrats than Republicans if the U.S. were to default on its debt, strengthening Senate Minority Leader Mitch McConnell’s position as he urges his members to oppose raising the borrowing cap. According to Politico, 33% of respondents said they would blame Democrats as opposed to only 16% saying they would fault Republicans (42% said they would blame both parties and 9% said they didn’t know).
The problem with assuming Democrats will lift the debt ceiling through the reconciliation bill, however, is that the reconciliation bill itself is in peril. In August, House Speaker Nancy Pelosi (D., Calif.) promised centrist Democrats that the House would vote on the $1.2 trillion infrastructure bill by Sept. 27. As that date approaches, progressives and centrists remain gridlocked. Moderates want to bring down the reconciliation price tag and progressives want to prevent that, each using one bill as leverage over the other. The centrists have threatened to kill the $3.5 trillion bill if the House doesn’t vote on the $1.2 trillion bill as promised, while progressives say they will scuttle the bipartisan infrastructure bill if the House votes on that one before the $3.5 trillion package is completed and ready for a vote.
“There could be a moment in the coming week or two when it looks like the whole process could collapse,” says Gardner. He says Democrats can’t exactly afford to let that happen because it would be “catastrophic” for Democrats in the 2022 midterm elections. While he continues to believe both bills will eventually pass—with the $3.5 trillion bill significantly scaled back to around $2 trillion—he warns that the odds of a total collapse of the two spending bills are rising. Gardner puts that chance at about 20%; a few weeks ago, he placed that chance under 10%.
As risks of a government shutdown, prolonged debt ceiling fight, and spending bill collapse rise, already-shaky markets have that much more to worry about. Gardner reminds investors that government shutdowns aren’t infrequent and markets usually recover quickly from shutdown-induced declines, but declines can still be sharp. Ahead of the shutdown that lasted 35 days at the end of 2018 into 2019, the
S&P 500
sold off about 11% but recovered by the time the shutdown ended.
The debt ceiling is a different story. The stakes, which include a potential default and credit-rating downgrade, are much higher and a related market drop could thus be much sharper and more prolonged. Gardner says that around the 2011 debt ceiling standoff, the S&P 500 dropped roughly 18% starting in late July after a deal that month was followed by a credit-rating downgrade in early August. The S&P 500 didn’t recover to its July levels until February 2012.
Chances of a default are still remote, and Congress will likely increase the debt ceiling, but the path to a deal is murkier than usual, Gardner says. “The political game of chicken could spook investors into a risk-off trade in the coming weeks,” he says. That’s at a time when investors already have plenty of reasons—from changing monetary policy, slowing growth and rising inflation to a potential default of China’s Evergrande—to already be skittish.
Write to Lisa Beilfuss at lisa.beilfuss@barrons.com
