September 30, 2013
- Unless an 11th hour deal is struck, the government will shut down at midnight tonight.
- Memories are fresh from similar "fiscal follies" in the summer of 2011 and we'll compare and contrast.
- The last shutdown was 17 years ago and a look at that history may also be instructive.
The Economist/YouGov poll shows the approval rating of Congress at 9%. It makes one wonder who are the 9% who think they're doing a good job. Here we go again with the specter of a government shutdown late tonight and another debt ceiling fight right behind it. It immediately takes many investors back to the turmoil in August 2011 when we last went through this "exercise" (exercise is supposed to make us feel better).
First, let's highlight some of the basic details, courtesy of Schwab's own DC guru, Mike Townsend. If you're already aware of the details (or you're tired of reading about them), skip ahead three sections.
When and why would a government shutdown take place?
The current agreement to fund government operations runs out today, meaning a government shutdown would take place at midnight tonight without a new agreement. Congress has been unable to pass a budget and the accompanying appropriations bills for the past four years, and this year is not different. As a result, the government has been funded by a series of temporary agreements, called "continuing resolutions."
The last agreement was reached in March and funded the government through September 30, the end of the fiscal year. Once that agreement expires, only "essential" federal government operations can continue. There has not been a government shutdown since 1996.
What would a government shutdown actually mean? Who would be affected?
All of the federal agencies have extensive contingency plans in place for determining who is an "essential" employee and who is not. An estimated 800,000 federal workers would be deemed non-essential and be furloughed, without pay, as of October 1. Even those workers who are deemed "essential," are not likely to be paid until the shutdown is over.
Some of the most visible signs of a shutdown would be the closing of national parks and all federal landmarks, museums and monuments. Passport applications won't be processed. Most federal agencies would be down to bare-bones staff, able to do essential functions but halting a lot of things. The SEC, for example, will continue to monitor the capital markets and accept financial statements from companies, but enforcement proceedings will halt and IPO filings will not be reviewed.
Lots of government functions, however, will continue to operate as usual. The military will continue to function. Mail will continue to be delivered because the Postal Service does not receive its operating funds from the Congressional appropriations process. Air traffic controllers and airport security screening will not be affected; nor will FBI agents or Border Patrol. Social Security payments and food stamps will continue to flow. But those who asked for a six-month delay in filing their taxes won't get a reprieve—those are still due October 15.
What is happening with the debt-ceiling debate?
The US government hit the current debt ceiling of $16.7 trillion in May. Since then, the Treasury Department has been using what it calls "extraordinary measures" to avoid defaulting on the country's debts. Last week, Treasury Secretary Jacob Lew updated Congress with a letter that said Congress will be nearly out of available cash by October 17. That date has become the new target date for getting a debt ceiling increase passed through Congress. There may be some wiggle room in that date, but it appears certain that Congress will have to increase the debt ceiling well before November 1.
The debt ceiling debate is going to be even more complicated than the debate over funding the government. President Obama has said that he will not negotiate on the debt ceiling and that he will only sign a clean bill that does not contain other items. House Republicans see the debt ceiling fight as a place where they have more leverage to extract concessions from the White House on some of their priority issues and they are really putting all their energy into that battle.
The House is considering a measure that would lift the debt ceiling through December 2014, but that bill has a laundry list of items attached to it, including a one-year delay of the health care law, approval of the Keystone pipeline, a framework for tax reform, and some changes to Medicare. None of those things are likely to be palatable to Democrats in the Senate.
Moreover, if Congress approves an extension of government funding only through December 15, then that means another government shutdown is looming in just 10 weeks. That debate is likely to get wrapped into the debt ceiling debate—increasing even further the difficulty of finding an agreement. There remains no clear path to getting this important issue resolved.
Recent precedent with similar Washington budget showdown in 2011
I'll get to the actual last government shutdown 17 years ago shortly, but let's start with a comparison between today and August 2011, the last time we went through this DC rigmarole. Clearly, the stock market is taking it on the chin today; but so far it's nothing compared to the market turmoil from the summer of 2011. We've been a bit cautious about stocks since early August; initially due to sentiment and technical concerns; but more recently about seasonal tendencies and DC's fiscal follies.
Recall that there was an 11th hour budget deal in August 2011 (literally an hour before the government was to shut down). That appears to be less likely today given that there is now a much wider gap between what the two parties want; not to mention the fact that there is absolutely no negotiating occurring, which was not the case in 2011. Sadly, a market riot may be "necessary" to get an eventual deal done.
But there are cushions today vs. 2011
With the theme of "a picture paints a thousand words" I will highlight a number of factors-- both economic and market-related-- that are quite different (and better) today than in August 2011.
The deficit has plunged.
The Fed's balance sheet is much larger
Economic numbers have been surprising on the upside
Consumer confidence is higher
Business confidence is higher
Overall economic policy uncertainty is much lower (although likely headed higher)
Initial unemployment claims are much lower
Job growth has improved
Stock market volatility is lower
Related to lower stock market volatility is less impact from High Frequency Trading firms. They represented over 70% of NYSE trading volume in the summer of 2011; while today it's less than 50%, given a less-ripe playing field for their game, and also the glare of the SEC's investigation spotlight.
Other comps
We also had the specter of a debt downgrade by one of the ratings agencies; which we did get by Standard & Poor's in August 2011, immediately after the last minute debt ceiling agreement. This is less likely at present. Support for that view came from Moody's recently when it upgraded the US outlook to Stable, and noted last week that even if there is a government shut down or debt ceiling delay, the country's AAA rating is not imminently at risk.
However, Moody's issued a new release today in which they noted: "Financial market and economic consequences would likely be more severe if the debt limit is not raised than under a government shutdown. Although the expenditure reduction under the debt limit scenario is smaller, the perception that the US government could default on servicing its debt if the debt limit is not raised could roil financial markets and damage business and consumer confidence."
Moody's also wrote that they view a temporary default (and downgrade) as unlikely even if the US government reaches the October deadline. However, it would be more disruptive to markets than a shutdown (in Moody's view) and there is little precedent on what payments would be made first.
Another point on the jobs effect: Although I showed the improvement to both unemployment claims and payrolls in the charts above; and the decline in policy uncertainty; it's becoming clear that this uncertainty has affected job growth. A July 2013 study by two economists in the Federal Reserve Board- San Francisco's Economic Letter found that "if there had been no policy uncertainty shocks, the unemployment rate would have been close to 6.5% instead of the reported 7.8% in late 2012."
But possibly the best cushion we have going for us now is global growth, which has recovered nearly everywhere; including in Europe, Japan and China.
Looking back at 1995-1996
There have been 17 government shutdowns since the current budget process began in the mid-1970s; the last two occurring in back-to-back fashion in late-1995 and early-1996. As you can see in the table below, the stock market suffered modestly before, during and in the immediate aftermath of shutdowns; but rebounded thereafter.
1995-1996 experience
There are a number of differences between today and late-1995, when the government initially shut down:
- The budget deficit was 2.2% of GDP then vs. over 4% today.
- Federal government debt was 47% of GDP then vs. over 72% today.
- The unemployment rate was 5.6% then vs. 7.3% today.
- The 10-year Treasury yield was nearly 6% then vs. 2.6% today.
- President Clinton's approval rating was 52% then vs. President Obama's 45% today.
- Republicans controlled all of Congress vs. only the House today.
- Congress agreed to backdate pay for affected employees then vs. no guarantee today.
- Monetary policy was a lever that could be pulled then vs. today's zero bound for rates.
- The end of the shutdown then settled the issue of government funding and spending vs. today when it will simply roll into the debt ceiling fight.
As you can see in the table above, the impact on the stock market in 1995-1996 was miniscule; with a massive shoot higher by stocks in 1996. Some of that was likely a function of Washington being seen more as a sideshow relative to the main event of strong earnings growth. Today, Washington is in the main tent, with earnings (for now) the sideshow.
Current costs of a government shutdown
The ultimate cost of a shutdown depends on both the length of time as well as the process for it ending. The 1995-1996 dual shutdowns lasted a cumulative 28 days. The estimates for the cost to GDP then range from 0.25% to 0.5%. Consensus is that if we do have a shutdown tonight, it's unlikely to last as long as the one in 1995-1996.
Ned Davis Research just put out a note today with some details on the possible hit(s) to growth. Assuming, similar to 1995-1996, that 36% of federal employees will lose pay during a shutdown, they estimate the direct impact on nominal GDP will be about $23 billion (annualized), which subtracts about 0.1 percentage point from fourth quarter nominal GDP. A one-month shutdown would reduce GDP by just under $100 billion, which is about 0.6 percentage points for the quarter.
Besides the direct GDP impact from lost wages, there are numerous indirect effects which could slow the sluggish recovery. Some include:
- Since the Federal Housing Authority (FHA) is scheduled to furlough about 96% of its workforce, all homebuyers counting on an FHA loan approval will have to wait.
- Payments to most private contractors would be delayed.
- Applications for Medicare, Social Security, veterans' benefits, immigration/visitors visas and passports will be delayed.
- Consumer and business confidence could suffer.
Conclusion
We have been in the camp expecting some rougher sledding for the stock market amid higher volatility. We have no better ability than anyone else to judge the ultimate outcome of these events; although we don't believe the bull market in stocks is over. It's likely only the pause button that's been pushed; but for those investors who are more trading-minded I'll repeat what I wrote in my August report highlighting near-term risks: You may want to hold your cards close to the vest … but don't fold 'em.
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