The last several weeks, there has been a lot of chatter over the looming potential government shutdown and debt ceiling resolution. We thought we would spend this week reviewing each separately and their potential effects on investment markets. We will focus more on understanding the situation, rather than a minute-by-minute update.
The federal government’s fiscal year begins October 1st. As required by the Constitution, all three branches must be funded through the appropriations process in Congress by then. If appropriations bills are not approved before the start of the fiscal year, Congress can pass a continuing resolution (CR), which provides interim funding before the appropriation bills can be passed. If neither an appropriation bill or CR is passed (or the CR expires without an appropriation bill passed), the federal government can experience a lapse in funding, creating a government shutdown.
In a government shutdown, all non-essential workers (non-national security related) get furloughed, which can impact rent payments, utilities, etc. Other ways you may notice the impact would be national parks potentially closing, delays in the release of economic data, delays in mortgage and other loan applications, IRS tax/refund delays, etc. Previously the CDC and FDA experienced a reduction in operations but given the current pandemic we would have anticipated these services maintaining more full staffing.
Occasionally, Congress and/or Presidents have weaponized government shutdowns as a way of accomplishing political goals not directly related to budgetary concerns. They act as a forced deadline which can accelerate or aid in negotiations. This is not new, in 2013 there was a 16-day shutdown in an unsuccessful attempt to repeal the Affordable Care Act. It was estimated that this shutdown took $24 billion out of the economy and shaved 0.6% off annualized fourth-quarter 2013 GDP growth.
Investors biggest question this week was how would markets react to a shutdown, with some investors assuming a shutdown would roil an already uncertain market. Our assumption was a continuing resolution would be passed before the October 1st deadline, which luckily Congress was able to do. But even if they had been unsuccessful, we wouldn’t have anticipated a large reaction from the market.
Historically, government shutdowns have not had a meaningful impact on the stock market, as they are viewed as temporary. In the 14 shutdowns since 1980, the S&P 500 had a median return of -0.1% the day the budget expired, +0.1% during the shutdown, and +0.3% the day the shutdown was resolved. In fact, during the most recent and longest shutdown, the S&P 500 rose 10%.
A failure to address the debt ceiling on the other hand, would have much wider repercussions.
The debt ceiling/limit is the total amount of money that the US government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, interest on the national debt, tax refunds, etc. It does not authorize new spending, but simply allows the government to finance its existing legal obligations.
If the debt ceiling is not raised, the U.S. Treasury Department would use “extraordinary measures” to keep the federal government operating temporarily for several weeks. However, Yellen announced this week that beyond October 18, 2021, the federal government could default. It is important to address that this would almost certainly be a technical default, where payment deadlines are missed by a day or two rather than an actual default in which payments are not made at all. The Treasury would likely continue to pay treasuries as they come due by auctioning new treasuries to pay the maturing ones (likely at a higher cost). But other payments to agencies, contractors, Social Security beneficiaries, and Medicare providers would likely be delayed until the Treasury had enough cash to pay its debt obligations. The Congressional Budget Office estimates non-debt maintenance federal spending would have to be cut by at least 40%.
It would be tough to understate just how important continued payment of US debt is to the global economy and the financial system. To put it in context, in the last close call (October 2013) the Federal Reserve simulated the effects of it taking just one month to resolve the issue. It estimated that it would lead to an 0.80% basis point increase in 10-year Treasury yields, a 30%+ decline in the stock market, a 10% decline in the value of the dollar, and a hit to household and business confidence that would lead to a two-quarter recession.
In 2011 Congress narrowly avoided a default and as a result the US was downgraded from AAA to AA+. The Government Accountability Office (GAO) estimated that the 2011 delay in raising the debt ceiling increased government borrowing costs by $1.3 billion in 2011, while the S&P 500 fell nearly 20% before recovering.
The length and circumstances surrounding any default will of course matter, but the main point is simple, the consequences for pushing this issue over the edge can be severe.
Our focus is on the debt limit, as we demonstrated that a government shutdown has not historically materially impacted financial markets.
Since 1960 Congress has raised or suspended the debt limit 78 separate times (49 under a Republican president and 29 under a Democratic president), almost always on a bipartisan basis. Therein lies the problem, as mid-term congressional elections approach, Republicans are refusing to be part of changing the debt limit and Democrats only want to change the debt limit on a bipartisan basis. Democrats in Congress could pass the appropriation and debt limit resolution unilaterally (although it would take some time) but instead they remain locked in a game of chicken with Republicans, each trying to force the other’s hand.
Given that Democrats could pass the resolution unilaterally, the historical track record of debt limit issues being resolved, and the catastrophic economic consequences that would result from playing around with this issue, we view the risk of a technical default as very low. That being said, we will continue to monitor the situation, but we believe this will be resolved over the next few weeks. Clients shouldn’t be overly concerned with the political posturing and volatility surrounding this in the interim.