The impending shutdown of Federal government services is unlikely to have much impact on capital markets, or leave much of an imprint on the U.S. economy.
History shows that, after previous shutdowns, backdated wages are paid and there is little hit to aggregate consumption. It is highly unlikely that debt interest, or capital repayments, will be halted (indeed, the yield on one-month Treasury notes at 5.44% has barely moved since late July).
Goldman Sachs think a shut down will end after 2-3 weeks, with pay day for active military personnel (October 13) triggering its conclusion. The bank estimates a hit to GDP of 0.2 percentage points a week to Q4 numbers. This is not insignificant, but even if we, as investors, knew in advance that three weeks of shutdown were coming, it is not clear how one might respond.
The potential hit to near-term GDP may persuade some to make an asset allocation call (sell equities, buy cash perhaps?).
But should investors be out of economically-sensitive assets when the backdated pay checks are cashed and the money spent?
Big Picture worries
For Big Picture analysts, there is of course the worry that the shutdown is symptomatic of a broader problem facing the U.S. – that of poor governance and massive public debt, themes that could intertwine to cause mayhem at some point in the future.
The shutdown is, after all, a re-opening of June’s Fiscal Responsibility Act that Congress agreed to and President Biden signed off in June. It was supposed to put the debt ceiling debate on hold for two years.
No other major economy goes through the same odd process as the U.S., whereby the legislative body approves a budget, but allows itself the right to re-open negotiations later, with the threat of not supplying the necessary funding. Often for political grandstanding, rather than any real commitment to budget discipline.
The debt rating agency Moody’s issued a report earlier this week, in which it noted that a shutdown would: ‘underscore the weakness of U.S. institutional and governance strength relative to other AAA-rates sovereigns’. And it showed ‘the significant constraints that intensifying political polarisation put on fiscal policy making at a time of declining fiscal strength, driven by widening fiscal deficits and deteriorating debt affordability’.*
This echoes the ‘erosion of governance’ complaint made by Fitch, in August, when it stripped the U.S. of its AAA rating.**
It is worth remembering that one explanation for China’s current slow economic growth is the burden of debt, much of which was acquired in the period of the global financial crisis to boost growth. Is the U.S, falling in the same trap today, with future interest and capital repayments likely to weigh down on U.S economic growth and investor returns?
This was the subject of the most talked about paper delivered at August’s Jackson Hole conference of central bankers, by Barry Eichengreen of Berkley. It discussed the limited options that western governments have in brining down debt over the coming decades and the negative impact of large debt burdens on growth.
Big picture stuff, interesting and worth considering for long-term strategic asset allocation perhaps. But not enough to warrant an immediate re-allocation of assets within an investment portfolio.
What’s it all about?
A cynic might say that Republicans in Congress are being bullied by extremists in their party. The Freedom Caucus’ scorched earth approach to politics is about winning Donald Trump’s blessing ahead of next year’s elections and it includes persuading other Republicans to act in the same way out of fear of Trump’s disapproval.
They have a fig leaf. Republicans in the House argue that the budget caps previously agreed are now too high, given the expected doubling of the budget deficit to a massive $2 trillion next year (around 7.4% of GDP – record for the U.S. outside of wartime or recession).
This is a reasonable point, though somewhat undermined by Republican nonchalance to deficits when they control the White House.
Unfortunately for Kevin McCarthy, Speaker of the House, Republican members struggle to agree amongst themselves where the cuts should fall. Nervous of attacking entitlements, such as Social Security, or defence and spending on veterans, the cuts must -by definition- be borne by discretionary spending items. These, such as transport and education, take up around a quarter of total spending, so will suffer disproportionately…yet are low in the lists of where Republican voters believe spending cuts should be made.
Meanwhile, some members of the Senate, which is narrowly controlled by the Democrats, hope that a re-opening of the budget debate will lead to a rise in the previously agreed spending caps. Given the size of the existing deficit, the cyclic mentioned above might wonder if some Democrats have lost the plot.
It is hard to see an agreement being reached by Sunday October 1 and how the shutdown might impact capital markets in the near term.
Investors should maintain a broad, balanced exposure to different asset classes and regions. Financial history show that this is approach delivers the best risk-adjusted returns over the long term.
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