As I type, there is still significant uncertainty about the debt ceiling. Will the Republicans give in and allow more spending, or will the Republicans stand firm and bring the government's operation to a standstill?
If the debt ceiling isn't raised on time to make the August payments on US Treasury securities, the only options would be for the government to immediately print money to pay the securities or for the US government to immediately shutdown operations, halting paychecks and possibly even halting all federal retirement checks and social security checks.
Because T-bills currently yield 0.02% or below, there is not a strong argument that there is significant need to curtail the debt limit. But of course, there is an argument that this economy is getting totally out of control, and taking any efforts which haven't been tried yet could be worth a shot.
Effects of the Republican Solution:
If the government is forced to shutdown even just for a few days or the debt limit increase is only very small, there will be no way for the economy to escape a double dip recession. The budget deficit will see immediate improvement, but incomes for much of the US will be lowered. This income reduction will result in an immediate drop in consumer spending, which will decrease GDP, but it will also help reduce the trade deficit. This will result in a strengthening of the dollar. So in other words, the Republican solution and threats will lead to a stronger dollar, but a definite recession. I believe this policy action would effectively take away power from the Federal Reserve and instead put the power in the hands of politicians.
Effects of the Democrat Solution:
On the other hand, using the Democrats' methods of upping the debt limit right away and without much caution will result in a continuation of what has been occurring for the past several years. The dollar will continue to weaken, which will stimulate net exports, and slightly boost the private sector job market. The Democrats' plan relies more on a waiting game for the Chinese yuan to be revalued properly to stimulate US exports, while the Republican plan attempts to force even more efficiency on the US economy without any crutches whatsoever.
Either plan will actually work, but politically the Republicans will have the ability to make it appear as if president Obama has destroyed the economy by putting it through two recessions, the second one occurring right before the elections. The truth, without party bias, is that the Republican plan is much harder on America in the short run, but better in the long run. The Democrats' plan is easier in the short run, but worse for the long run. With such a vicious economy, with seemingly no improvement in sight for years, there is a great argument for either direction. I think if the Republicans directed their government spending cuts energies on the war rather than on essential services and income to the poor, they would have nearly universal support. The logic being, if everybody is totally messed up anyways, why not just officially mess up hard and end the pain sooner? Kind of like pulling off a band-aid quickly rather than slowly. I tend to agree with that philosophy.
The problem is that Republican theory is not designed to improve the economy; it is designed to get their party members elected and nothing more.
Investment Decision Making:
I think it is somewhat safe to prepare for a recession at this point, but if the Republican plans go through, a recession is a near certainty. The recession will probably not hit that hard though because the economy is already in such ruins. The last recession we had would have been much, much deeper if government spending were not increased like it was. Those government jobs which cushioned the recession are now going to be erased due to lack of government ability to pay.
If the Republicans get their way, the best portfolio positioning for a recession will be to take long positions in high duration government bonds such as the (TLT) bond fund. With less debt issued, inflation is much lower of a concern, and the likelihood of a government default in the future decreases when fiscal policy is forced like it will be. Gold (GLD) will be undesirable to hold because fiscal restraint will cause the dollar to strengthen. Also, deflation could come around again if the recession is strong enough, further causing (GLD) to be undesirable. The flight to precious metals in past recessions would likely not occur because this recession would be because of fiscal restraint rather than increased US debt. At the least, Gold would stop its monumental rise. Stocks (SPY, QQQ, DIA), would likely be undesirable to own due to pressure on US exporters from the stronger dollar. In short, the Republican plan should make one bullish for government bonds.
If the Democrats get their way, government bonds (TLT) will weaken due to the increasing inflation pressure and the higher risk for a giant debt default in the future. Stocks would be more desirable to own because US exporters would have a weaker dollar to work with right away. Employment will be much, much better under the Democrats' plan, so real estate would likely be less risky versus the Republican plan. In short, the Democrats' plan should make one more bullish on US exporter stocks and real estate and bearish for government bonds.
My guess is the debt ceiling will be raised, but much, much less than the Democrats wished it would. This will probably result in a recession. This presents an opportunity for hedging market risk by taking short positions in stocks. Several major asset classes can be seen in the chart below (click to enlarge image):
Over the past year, government bonds are down roughly five percent, while gold and stocks are each up approximately thirty percent. This leaves plenty of room for stocks to fall and bonds to rise if the Republican plan goes through. If the Democrats' plan goes through, it seems unlikely that stocks will continue a significant rise, but they would likely hold on to most of their prior gains. The economy is slowing; it is just now a question of how much it will slow for the elections.