Image shows a picture of Lindsey Bell, Ally Invest’s chief investment strategist. The title reads “Debt Ceiling Crisis Averted, Drama Not Over.”

This week, Congress managed to avoid a worst-case scenario for the country: the first-ever default on its debt.

The market cheered, but the drama is far from over.

While we lived to see another day, it feels like Groundhog Day. The issues remain the same; the government just has a little more time to solve them. The debt ceiling and government funding will have to be revisited. Infrastructure and social spending policies will continue to be debated.

Economic growth and corporate earnings are at stake. We don’t believe much of the extra spending has been baked into estimates, but an operational government is imperative for the market to make new highs.

The good news is that while Washington can rattle markets with policy uncertainty, it rarely has long-lasting control over market direction.

Let’s discuss what “kicking the can” down the road can mean in the near-term.

Chart titled U.S. Debt vs. the Debt Ceiling. The debt ceiling has been changed or suspended 33 times since 1990, each time as the U.S. public debt amount approached the ceiling limit. The previous limit was set at $28.4 trillion in August 2021. That has now been raised for a limited time. Source: Ally Invest, Congressional Research Service, U.S. Treasury

Raising the Debt Ceiling

About a week and a half after Treasury Secretary Yellen warned Congress the country would run out of money to pay their debt obligations, Congress reached a resolution to raise the debt ceiling by almost $500 billion. It is estimated this will fund the government until December 3. The market cheered the bipartisan agreement with the S&P climbing as much as 1.5% on Thursday in response.

Despite the celebration, the debt saga is not over. The move gives the government more time to iron out how to best deal with the debt load, but it isn’t a long-term fix. The solution may lie in trade-offs within the $3.5 trillion planned social spending bill. To keep the debt from quickly reaching a new ceiling, the government may need to make cuts to spending plans or raise taxes. That won’t be as cheerful of an outcome for markets.

Looking for Near-term Clues

Given the government’s track record of taking major policy decisions down to the wire, we would expect the combined debate on the debt ceiling and spending bill to drive investor anxiety as we approach the end of November.

To determine the level of market uneasiness, we’ll watch gauges like the VIX “fear index,” 1-month Treasury yields and high yield corporate bonds. When the VIX jumps above 20, it can be a sign that investors are bracing for some negative news.

Chart titled Watching the VIX in Debt Ceiling Drama tracks the VIX against the VIX historical average from 2016 through 2021. The average sits at 20 and the VIX peaks and dips around it, generally staying between 10 and 40, except in 2020, when it spiked up to about 80. Source: Ally Invest, Bloomberg

A jump in the 1-month Treasury yield can indicate investors are worried about the debt ceiling being raised. We saw that type of move early this week as investors moved away from longer-term debt, since short-term debt would be more negatively impacted in a default. Finally, a large increase in high-yield corporate debt yields is a message that risk is rising in the market.

The bigger the moves in these indicators, the greater the pressure could be on the market.

We aren’t expecting a major surprise, but the details on how these policies are resolved could impact markets in the nearer term. If spending cuts and higher taxes are included in the proposed spending bill to help limit debt increases in the future, corporate growth expectations could be reduced. That would weigh on stocks. The nature and size of cuts to the currently proposed social spending bill will be key to the market’s reaction. A balancing act of getting a deal done by committing to put more money into the economy while not completely blowing out the country’s balance sheet could be well-received by investors.

The Bottom Line

The debt ceiling has been in the crosshairs many times, and we’ve managed to avoid a default with relatively calm markets most of the time. While more volatility may come as December nears, the bipartisanship of the past week gives us hope that acceptable deals on the debt ceiling and government funding will be made. Long-term, that is a good thing for the economy.

If you want to prepare for volatility, consider defensive sectors and dividends. Having cash ready for when volatility hits is another option. But remember, investing (or not investing) based on policy changes doesn’t work over the long term because the market has a tendency to move higher over time.

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Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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