The Market Impact Of A Possible Government Shutdown And Reaching The Debt Ceiling

If Congress does not act, a debt limit showdown with a possible government shutdown looms on Friday, October 1. In addition, Treasury Secretary Yellen has warned that the Treasury will exhaust its cash and extraordinary measures in October if the debt ceiling is not lifted. Unless the debt ceiling is increased, the U.S. cannot issue more debt. While a possible default on our U.S. debt will be discussed in the news if an agreement is not reached, a default is virtually certain not to happen. This debt ceiling argument is a political fight in which each side thinks it can extract something from the other.

According to Strategas Research Partners, the federal government collects about $4 trillion in revenue and has only $350 billion in interest costs. The federal government can fund defense, veterans, Medicare, Social Security, and health programs from cash flow alone. If the Democrats and Republicans cannot agree on terms to raise the debt ceiling, the federal government would eventually be forced to prioritize spending to avoid default and continue servicing the U.S. debt. In the end, Congress will raise the debt ceiling, but it may not happen before the government is forced to shut down for a period.

Typically, additional uncertainty does not benefit the performance of the stocks market, so it is instructive to look at past instances of government shutdowns. Interesting, the S&P 500 was usually higher on average during the past 14 government shutdowns since 1980. In fact, the most recent episode in 2019 had solid returns but was preceded by a seven percent sell-off. While the returns during the shutdown seem to be reasonably calm, there is some evidence of volatility around the shutdown period.

Recent debt ceiling crises leave a more mixed picture, however. In 2011, the U.S. began using extraordinary measures to service the debt on May 16, reaching an agreement on August 2. During that period, the S&P 500 fell almost -6%. It is unlikely that the debt ceiling was the only reason for the decline, as Europe was mired in a debt crisis, and economic growth was slowing.

In 2013, extraordinary measures were started on May 13, and an agreement was reached on October 17. During this period, the S&P 500 was almost 4% higher though stocks were down nearly -6% at one point during the period.

Investors should be prepared for more stock volatility if Congress cannot reach an agreement to raise the debt ceiling this week and keep the federal government open. History provides no reason to sell stocks due to an impending debt ceiling showdown or government shutdown; instead, any declines driven by the conflict are likely to be an opportunity for investors looking to increase exposure. While much of the tax and spending bills will likely take until sometime in the fourth quarter to be completed, Congress will also continue to negotiate the hefty tax and spending bills.

While Covid infections are continuing to rise in the U.S. and many other countries, the decline in the rate of change is some indication that things are beginning to improve. The momentum of U.K. infections seems to have peaked and continues to improve. After a rebound the previous week, the speed of increase in U.S. Covid cases finally posted a significant decline. Japan experienced the peak momentum was in late August and continues to improve.

As noted last week, the Federal Reserve (Fed) did not change policy rates. The updated dot plots show the Fed Governors equally split about whether there will be a 2022 rate hike. The Fed gave a stronger signal than expected that the official announcement for the start of the reduction in bond purchases or tapering seems likely to happen in November. Chair Powell noted that most Fed members favored tapering ending in mid-2022 which implies a reduction pace of $15 billion per month. While many market commentators viewed the meeting as a bit more hawkish than expected, the markets did not react negatively last week. With markets always worried about a premature reduction in Fed accommodation smothering the economy, the yield curve, which has accurately predicted most recessions when the yield on the 10-year U.S. Treasury has fallen below the 2-year, approved of the Fed meeting by rising. This yield curve steepening lifted bank stocks, as measured by the KBW Bank Index (BKX), by 3.1% for the week.  Value stocks, which are typically more economically sensitive, also outperformed for the week. The U.S. 3-month Treasury yield 18 months forward indicates less than two rate hikes over the next year and a half.