U.S. Government Shutdown: What It Could Mean For Stocks

by Jason Martin

As the US Congress returns from its summer recess on September 5, after the Labor Day holiday weekend, the specter of a possible government shutdown looms. Investors will likely begin to question what the ramifications may be for their equity investments.

Ever since the US's $19.8 trillion debt limit was hit back in March, the government has been using “extraordinary measures” to shuffle money and continue funding until an agreement is reached. Specifically, U.S. Treasury Secretary Steven Mnuchin has been suspending the issuance of new debt in order to keep government funds beneath the cap.

In a letter to congressional leaders sent on July 28, Mnuchin informed recipients that he would:

“...continue to be unable to fully invest the portion of the Civil Service Retirement and Disability Fund (CSRDF) not immediately required to pay beneficiaries.”

Mnunchin added that the CSRDF would be made whole, as required by law, once the debt limit is increased and explained that the suspension would not affect Federal retirees and employees. While, the government is officially funded through the end of its fiscal year on September 30, Mnuchin noted at that time that the suspension would continue through September 29, a mere 12 working days after Congress returns to session.

That said, the Congressional Budget Office has suggested the deadline, known as the “x date”, may be stretched a little longer, estimating that the government will not actually run out of cash until some point in early to mid-October.

In any case, both Congress and US President Donald Trump face the necessity of raising the debt ceiling in order to continue paying the country's bills. The increase in the limit of US debt is needed so that the government can borrow money in order to pay its bills as the Treasury runs out of “hard cash” to cover those payments.

If no accord is reached, a government shutdown would ensue, resulting in the suspension of all non-emergency government funding including worker furloughs, shuttering of public offices and facilities, shutdown of national parks and delays in government paperwork processing. The government would also need to decide who gets paid and who doesn't, meaning that bondholders could lose out on coupon payments, Social Security and welfare recipients may not receive benefits and government contractors, such as those providing services to the US military, might not receive their due.

Recent remarks from President Trump, insisting that funding must be included for the wall he promised to build on the border with Mexico, have increased market concern over the possibility of a shutdown. "If we have to close down our government, we're building that wall," Trump said at a rally in Phoenix, Arizona on August 22. "We're going to have our wall,” he emphasized.

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On August 25, Treasury Secretary Mnuchin sought to play down the possibility that the shutdown would occur. "I have had discussions with the leaders in both parties in the House and Senate and we are all on the same page,” he said. “The government intends to pay its debts and the debt ceiling will be raised," Mnuchin insisted.

However, the situation has since been further complicated by the extreme damage in the wake of Hurricane Harvey for which the government is expected to provide funds to support the victims.

Mnuchin warned on August 31 that Hurricane Harvey could bring forward the deadline by which the nation's debt ceiling needs to be raised while also noting that projections for the so-called “x date” may change with the receipt of corporate taxes on September 15.

Most recently, but prior to Mnuchin's warning, Trump did not back down from the possibility of a government shutdown.

At a news conference on August 28, in response to the question of why it would be necessary to shut down the government over the wall's funding if Mexico was going to pay for it, as Trump has repeatedly reiterated, the President said, “I hope that's not necessary. If it's necessary, we'll have to see, but I hope it's not necessary,” he said.

The House and Senate, both controlled by the Republican party, are widely expected to avoid a government shutdown by passing an interim spending bill, known as a continuing resolution, that would allow for temporary payment measures and could avoid a fight over budgeting for Trump’s wall.

However, the President’s signature would be required on such a measure which is why his recent threat of shutting down the government received widespread attention in the markets.

Markets are currently pricing in the odds of the US government reaching the breaking point by letting the deadline, or “x date”, expire without a continuing resolution in around the low-single digits. The need for additional funding for the damage caused by Harvey places political pressure on both parties to reach an agreement on raising the debt ceiling.

At the moment, the 2011 dilemma—wherein an impasse in Congress to raise the US debt ceiling at that time, caused Standard & Poor’s to strip the world’s largest economy of its treasured triple-A rating, a rank the US had held for 70 years—seems to be the closest parallel for the current situation.

Of note, in 2011, nerves over the impending showdown on the Hill sank the S&P 500 to 1,075 points in October of that year, a drop of nearly 20% from the beginning of July.

Since the beginning of July this year, the global benchmark is still up more than 1%.

In what appears to be another sign of relative calm, the VIX volatility Index, known as the fear gauge, is currently around 10 points, compared to nearly 34 six years ago and 46 in October 2011.

Of course, there is still quite a ways to go between now and the “x date” where volatility will likely rise and investors become nervous over the lack of a deal and the threat of a corresponding government shutdown.

However, historically, government shutdowns tend to be short-lived and rarely have a major impact on stocks.

As the chart from LPL Research below shows, the S&P has given negative returns in only half of the past instances where Washington has closed down and the drama, in the longest debacle, only lasted 21 days.