Remember that game of chicken in Rebel Without a Cause? James Dean and another teenager are racing in separate cars to the edge of a cliff. The first driver who jumps out of his speeding sedan will be deemed “chicken.” Dean bails first. The other kid tries to jump next, but gets tangled in his seat and plunges to his death.

Another dangerous game of chicken is the U.S. debt ceiling fight. As it races toward its deadline, Congress threatens to drive the economy and markets right off a cliff. Below, I provide four ways to protect your portfolio from impending fiscal catastrophe.

In Washington, when the going gets tough…lawmakers get out of town. House and Senate members left the Capitol on Friday, still far apart on the debt ceiling with no deal in sight. The U.S. could default on its debt as soon as June 1.

Odds are growing that Congress will let the default happen. Financial markets are finally coming to that conclusion. Short-term interest rates (the one-month U.S. Treasury) and the cost of insuring against default (credit default swaps) have spiked.

In years past, when the debt ceiling was weaponized by those in Congress who wanted drastic budget cuts, corporate and Wall Street lobbyists exerted pressure for a deal and a default was averted at the last minute. But this time around, a radical insurgency in the U.S. House would be content to plunge the economy into the abyss.

Moody’s recently warned that even a brief breach of the debt limit would wipe out roughly a million jobs and tip the economy into a full-fledged recession. The unemployment rate would jump from the half-century low of 3.4% to about 5%. Financial markets would get slammed.

The contracting economy…

The debt ceiling brinkmanship is occurring amid an economy that’s already contracting. Four economic reports released this week show that the Federal Reserve’s aggressive tightening is exerting the desired deflationary effects, but at a cost in jobs and growth.

The U.S. Bureau of Labor Statistics (BLS) reported Wednesday that the consumer price index (CPI) increased 0.4% in April, in line with the consensus estimate. The year-over-year increase came to 4.9%, below the 5% estimate.

Excluding volatile food and energy prices, “core” CPI rose 0.4% monthly and 5.5% from a year ago, both in line with expectations.

The BLS reported Thursday that wholesale prices rose in April by less than consensus expectations.

The producer price index (PPI), which measures the prices that domestic producers of goods and services receive, edged higher by only 0.2% last month, below analysts’ expectations of 0.3%. The core PPI also rose 0.2%, in line with expectations.

On an annual basis, headline PPI rose only 2.3%, less than the 2.7% year-over-year growth reported for March and the lowest PPI reading since January 2021.

A separate report released Thursday by the Labor Department showed that new jobless claims for last week climbed 22,000 to 264,000, versus expectations of 245,000 and the highest reading since the end of October 2021.

The University of Michigan reported Friday that consumer sentiment in May dropped to 57.70 (see chart).

The report stated:

“Consumer sentiment tumbled 9% amid renewed concerns about the trajectory of the economy, erasing over half of the gains achieved after the all-time historic low from last June. While current incoming macroeconomic data show no sign of recession, consumers’ worries about the economy escalated in May alongside the proliferation of negative news about the economy, including the debt crisis standoff.”

Investors are trying to digest the mixed message of these latest economic reports. They’re deflationary, but on the other hand, they renew fears of recession.

The main U.S. stock market indices closed lower on Friday, in choppy trading, as follows:

• DJIA: -0.03%
• S&P 500: -0.16%
• NASDAQ: -0.35%
• Russell 2000: -0.22%

The decline in recent days of the small-cap oriented Russell 2000 is an ominous sign, because it points to expectations of a recession. Investors are coming to the conclusion that risk assets are perhaps priced too richly for the worsening economic downturn that’s looming on the horizon.

WATCH THIS VIDEO: The Fed Pause: Will It Be Too Late?

Corporate earnings are providing a countervailing tailwind for equities. So far, about 85% of companies in the S&P 500 have reported first-quarter 2023 earnings, and 79% of companies have beaten consensus estimates, higher than the one-year average.

The better-than-expected performance of Q1 earnings suggests that the decline of earnings growth is bottoming out, as companies cut costs and reduce payrolls.

Forward guidance also has been strong, but a debt ceiling default would immediately change those outlooks for the worse.

Four protective steps to take now…

As lawmakers squabble over the debt limit, here’s how you can mitigate risk to your portfolio:

1) Reduce exposure to companies that rely on Uncle Sam for revenue (e.g., health care providers, aerospace/defense contractors, and infrastructure builders).

2) Increase your exposure to overseas equities. A well-diversified portfolio should contain international stocks; boost your stakes in these assets.

3) Put a greater percentage of our portfolio into ultra-safe havens, such as money market funds. Money market investing can be advantageous if you need a short-term, safe place to ride out a crisis. Due to rising interest rates, money market funds now offer more than 4% a year.

4) Use stop-loss orders. One of the most widely used devices for limiting the level of loss from a dropping stock is to place a stop-loss order with your broker. Using this stop order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.

If the last price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.

There’s still a chance, of course, that cooler heads will prevail and some sort of deal (or legal maneuver) will avert a debt default. But in the meantime, brace yourself for the worst.

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John Persinos is the editorial director of Investing Daily.

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