A Government Shutdown Catastrophe…

Typically gridlock in D.C. is bullish for the markets. Gridlock keeps any meaningful legislation from being passed and removes an uncertainty from the equation. However, if the House and Senate aren’t able to reach a deal on a government spending bill by September 30th, the federal government will shut down. At the time of this writing there had been no bill passed. The last time the Federal Government was shut down was at the end of 1995 and early 1996 when it was shut down twice for four weeks combined. The shutdown was the result of conflicts between Democratic President Bill Clinton and the Congress over funding Medicare, education, the environment and public health in the 1996 budget. The government shut down after Clinton vetoed the spending bill the Republican-controlled Congress sent him. The Federal Government put non-essential government workers on furlough and suspended non-essential services from November 14 through November 19, 1995 and from December 16, 1995 to January 6, 1996.

What Was Old is New Again
Back then, a majority of congress members and House Speaker Newt Gingrich, had promised to slow the rate of government spending, however, this conflicted with the President’s objectives for education, the environment, Medicare and public health. When President Clinton refused to cut the budget the way the Republicans wanted, Gingrich threatened to refuse to raise the debt limit (sound familiar?).

Today something very similar is happening except this time it’s mostly about “Obamacare.”  Republicans want to defund the relatively recently passed healthcare legislation to keep it from ever being fully implemented. It is highly unlikely congress will allow a government shutdown, so the most likely scenario is republicans acquiesce and the government stays open. Republicans don’t want to spend the political capital and potentially harm themselves in the next mid-term elections.

This is also setting the stage for another round of fighting about whether or not to raise the debt ceiling. Treasury Secretary Jack Lew has been sounding the alarm on this issue recently, saying by mid-October the government won’t have enough money to pay its bills. This is even earlier than he thought just a couple weeks ago. Even if we avert a government shutdown, the uncertainty won’t end there. The market will also have to deal with republicans and democrats fighting another 12 rounds before eventually raising the debt ceiling, which I believe will happen. The chance of the U.S. defaulting on its debt service is almost zero.

Kicking the Can Down the Road
Every year, the federal government is supposed to agree on 12 appropriations bills to fund federal agencies and set spending priorities. Due the extreme bipartisanship in D.C., Congress seems to do more arguing than actually passing legislation. Everything is susceptible to being used as a political bargaining chip, including keeping the government running. So instead of passing bills, Congress has been passing “continuing resolutions,” a stopgap measure to keep things running. The last one expires on September 30th. Here’s the rub: Republicans and Democrats can’t even agree on a stopgap measure or a “continuing resolution.” The House version included an item that defunded Obamacare. The Senate bill will most likely pass without that provision.  The result is a standoff in which case, no one wins.

How Will a Shutdown Affect the Economy?
The economic effect of a shutdown depends on how long it lasts. If it’s just a few days, I don’t believe it will have much of an impact on economic growth. It could, however, rattle the markets in the short-term, potentially causing a long overdue correction. If it lasts for a few weeks, the impact will be worse. The last time the government shut down it is estimated it shaved about a half of a percentage point of GDP for the fourth quarter, 1995.

While I believe the U.S. and global economies are expanding and poised to continue growing, there is little doubt the economy was healthier in 1995 and 1996. We were in the midst of a 10-year bull run and a tech-led boom was about to occur. A government shut down could hurt more this time around as the economy isn’t growing like it was for most of the 90s. The effect of a shutdown is also dependent on the scope. There are many functions that will continue as they always have.  Anything related to national security, public safety or programs written into law, like Social Security, will remain intact. Federal workers are separated into two classes; essential and non-essential workers. The essential workers will continue to show up for work while those deemed non-essential will be furloughed.

However, like the debt ceiling, I believe this will be resolved before we hit the deadline and if not, then soon after. Congress knows the economy is not as strong as it was in 1995 and 1996 and does not want to impede economic growth in any way so the likelihood of a resolution is high. With millions already out of work, it’s unlikely the government would send home another 1.2 million workers, which is how many workers the government estimates it would furlough in the event of a shut down.

Putting it All Together
If there is a protracted government shutdown (unlikely) it would be a negative for both the economy and the market. It would increase uncertainty for businesses, which would impede new investment and new hiring. Secondarily, it could force the Fed to continue with its Quantitative Easing longer than it would have, which in and of itself, I consider an overall negative on the economy and would like to see the end of sooner rather than later. If I’m correct that there will be no shut down, or a very short one if it does occur, I believe the stock market will shake it off as a non-event. But as I said earlier, it could cause gyrations in the market in the short-term as Congress goes back and forth on the issue. Risk aversion will increase and cause some panic selling, possibly a full-blown correction. But in the long run, I believe it will have little effect on stock returns. The U.S. and global economy is expanding and there are unrecognized strengths here and abroad. A government report released Thursday said GDP grew at an annual rate of 2.5% in the second quarter, not great but it’s still growth. Spending on durable goods rose 6.2%. With so many investors focused mainly on negative headlines and ignoring all the positives surrounding the economy, the chance for upside surprise increases. I believe once these strengths are recognized, the bull market will climb the proverbial wall of worry and continue higher.

 

by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.

Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

 

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