Government Shutdown: Stock Market Impact

While the threat of an immediate government shutdown appears to have been averted by a continuing resolution (CR) between Democrats and Republicans, there remains a substantial likelihood that a shutdown will occur in the next two months. If that happens, it would significantly increase the risk of a stock market correction.

-Threat of a shutdown remains real

The Wall Street Journal, in this Saturday’s headline story, reported:

Senate Democrats have now softened their resistance to cuts. They are assembling a new measure to fund the government for the rest of the year, aides said, but the cuts it includes aren't expected to generate savings anywhere near those that House Republicans have proposed. That means that even if the two parties can reach a short-term compromise to keep the government open after Friday, they will face a substantial challenge in coming to agreement on a broader deal in the few weeks available before the prospect of a shutdown arises again.

The gap between the parties’ positions is really a chasm. The Democrats have agreed to $39 billion in cuts for the full fiscal year from President Obama’s original budget submission (i.e. the domestic spending freeze), while the Republicans are seeking $100 billion in cuts. A compromise midway between these positions is problematic. Neither party has demonstrated a willingness to make the major concessions that would be required to reach that middle ground. The Democrats will resist cuts of that magnitude fearing the adverse impact on economic growth and their constituencies. The Republicans committed to $100 billion of cuts in the November election and intend to carry out what they now regard as a mandate. They are under intense pressure from media outlets like Fox news, deficit hawks and, “tea party” advocates to carry out their pledge.

The Democrats recall that the 1995-96 Clinton-era shutdowns were a disaster for the Republicans that turned the tide in their favor. Many Democrats believe that a shutdown this year would be a repeat performance. They are also convinced that once the public becomes more educated about specific programs slated for cuts by Republicans, support for the general cutback will diminish. In short, both parties are highly motivated to make only limited concessions.

Thus far, party leaders have been engaged in a public relations battle to place blame on the other for any future shutdown. The short term extension of government operations delays a shutdown but does not necessarily move the parties toward resolution of their substantive differences. The risk of a shutdown in the next two months is in the 50% range.

-A shutdown would pose a serious risk for the stock market

During the brief shutdowns in 1995 and 1996, the market did not correct. Stocks rose modestly during those periods. However, there are reasons to believe that this time the impact would be different.

After the big stock market run up of the past six months, there is a growing sentiment that the market is due for a correction. Some traders are looking for an event to set it off. The government crises in the Mideast have already moved market sentiment to shakier ground.

The shutdown in 1995 lasted 5 days; in 1996 it lasted 21 days. The divisions between the parties on the appropriate size and nature of budgets cuts are deeper this time around and may take more time to resolve. Any further extensions of the CR will be increasingly difficult to achieve.

If a shutdown occurs, it will bring in its wake adverse economic effects that will worry the market. In 1995 and 1996, only about 40 percent of federal employees were affected, since the government can maintain a relatively large chunk of essential and mandatory services even without a CR. According to a Goldman-Sachs analysis, a shutdown affecting 40 percent of federal employees would result in an $8 billion revenue loss to the economy per week. Their report concluded, “Pulling this spending out of Q2 would reduce the contribution to quarterly GDP growth from federal activity by a little more than 0.8 percentage points at an annualized rate for each week the shut down lasted.” In addition, there would be delays in awarding government contracts, which also contribute to the economy.

A shutdown will also increase concern about the impact on the gross domestic product of the ultimate plan. In another report, Goldman analysts warned that the Republican plan to slash government spending could reduce economic growth by 1.5 to 2 percentage points in the second and third quarters of the year. Similar warnings have been made by Treasury Secretary Timothy Geithner, economist Paul Krugman and numerous Democratic leaders. If these projections are correct, even a midway compromise will be damaging.

There is also the threat that a shutdown could result in a serious crisis of confidence in the ability of our governmental institutions to function effectively. Deadlock and stalemate have characterized Congress in recent years. As Yale economist Robert Shiller repeatedly warns, psychology has an enormous impact on the functioning of the economy and markets. While confidence in the economy has grown significantly over the past few months (as measured by consumer confidence indexes), it remains fragile as the result of the setbacks suffered during the recession. A shutdown could result in reversing that positive trend.

The takeaway for investors is that there is a substantial risk that the government will shut down and the stock market will suffer a correction in its wake. The wise investor will keep abreast of the rapidly changing events and adjust appropriately.

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click here to read Part I of this Newsletter, the article "Why Successful Investing Is 90% Psychological" by Tom Madell.