Ned Davis Research Group reminds us that the federal government has been shut down 17 times since the current budget process was developed in the mid-1970s. While the longest shutdown spanned 13 stock market trading days, the median shutdown spanned just two trading days. Now underway is the 18th shutdown in roughly 40 years and the first since 1996. One other bit of perspective: It overstates the sorry state of affairs in the nation's capital to say that the federal government has been "shut down." For the sake of simplicity, we, like many others, refer to the development as a shutdown, but in reality some two-thirds of federal workers, including our soldiers and air traffic controllers, remain on the job. It is nonetheless significant that some 800,000 U.S. workers have been furloughed.
Expect an increase in market volatility
At this time, our Investment Strategy Team has decided to maintain the mixes of its model asset allocation strategies. Similarly, we see no reason for long-term investors with well-considered investment plans to alter their portfolios based on the D.C. follies.
Periodic "air pockets" in the financial markets seem likely as the political dust settles in the next week or so. As in 2011, there are few places for investors to hide and certainly none with the size and liquidity of U.S. markets. In the absence of meaningful changes in the political or economic landscapes, or in the financial markets, we would expect to view any significant near-term drop in stock prices as a buying opportunity.
Investors may not go en masse into "risk-off" mode—selling risky assets in meaningful quantities and causing us to reevaluate the construction of our model strategies—unless it looks as if the U.S. debt ceiling will not be raised.
Raising the debt limit is key
The critical issue is what happens with the U.S. debt limit, or ceiling—currently $16.699 trillion. The total debt outstanding subject to the limit is now $16.653 trillion, according to Strategas Research Partners. The budget crisis could linger for a couple weeks and get intermingled with the debate over the debt ceiling.1 We don't believe our elected leaders want to see what would happen if they fail to raise the debt ceiling—as they have 14 times since 1997, according to the Concord Coalition—so a last-minute, mid-October deal combining an increase in the debt ceiling with a continuing budget resolution, which could put most if not all furloughed federal workers back on the job, would not be surprising. A deal could be struck sooner, especially if financial market volatility rises meaningfully, or one party or the other's poll numbers change dramatically. A deal in D.C. that arrives sooner than most expect could lead to a rally in risky asset prices.
Potential effects of the shutdown on U.S. economic growth
We believe the underlying, annualized trend rate of U.S. economic growth remains 2.0–2.5% above the rate of inflation. The government shutdown will knock the actual rate of growth temporarily below that trend rate, absent any offsetting positive facts, such as an increase in exports as the dollar weakens. The direct impact is the loss of some $23 billion in weekly pay to furloughed workers (source: Ned Davis Research Group). Indirect impacts would include any loss of consumer and business confidence, which could crimp spending and further erode the growth rate. In the second quarter, the economy grew at an annualized rate of 2.5% on an inflation-adjusted annualized basis, so at present we view the probability of recession as quite low.
Relative to the environment we experienced when the president and Congress had their last debt ceiling confrontation in 2011, we are in much better shape economically. The unemployment rate has dropped, housing has begun to recover, and Europe appears to be turning the corner on its recession. Importantly, while the rate of corporate earnings growth has ebbed, the level of profitability remains high by historical standards. With the Federal Reserve continuing to suppress longer-term interest rates by buying some $85 billion worth of Treasury and mortgage-backed securities each month, and by continuing to target short-term interest rates of 0.00–0.25%, we continue to favor stocks.
1 In a letter to members of Congress dated October 1, U.S. Treasury Secretary Lew wrote, in part: ?It is important to note that once the final extraordinary measures are exhausted, no later than October 17, we will be left to meet our country's commitments at that time with only approximately $30 billion. This amount would be far short of net expenditures on certain days, which can be as high as $60 billion. Although the current lapse in appropriations creates some additional uncertainty, we do not believe it will impact our projections materially unless it continues for an extended period of time. If we have insufficient cash on hand, it would be impossible for the United States of America to meet all of its obligations for the first time in our history.
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