As the federal government’s fiscal year drew to a close, the inability of Congress to reach an agreement to fund the government and the reality of a U.S. government shutdown has once again taken center stage. With lawmakers in Washington struggling to reach consensus, investors are left to assess the potential economic and market implications of a lapse in federal funding.
It’s important to note that the shutdown doesn’t extend to various essential services that will continue, such as those related to the functioning of Social Security and Medicare, national defense and border security, and air traffic control, as examples.
Economic context: Limited but duration matters
A government shutdown, while disruptive, is far from unprecedented. Since 1976, there had been 20 shutdowns (prior to the current one), ranging in length and severity. Most have been resolved in a matter of days, but the most recent, which started in late 2018 and extended into early 2019, lasted 35 days — the longest in history. It was exacerbated by the fact that it took place during a period of turnover in Congress after the 2018 midterm election, which resulted in significant turnover in the House, ultimately being resolved after the new Congress was sworn in. Even in that unusually long shutdown, the economic impact was an estimated 0.1 to 0.2 percentage points shaved off GDP growth for the impacted quarters, according to the Congressional Budget Office.
This time, the economic backdrop is more nuanced. Recently revised GDP data indicated that the economy grew at a crisp 3.8% pace in Q2 and seemingly carried solid momentum into Q3. Conversely, the hiring environment has softened considerably, inflation remains sticky, and the Federal Reserve continues to walk a tightrope between curbing price pressures and supporting growth and employment. The recent decision by the Fed to cut its benchmark policy rate by a quarter-point reflected their assessment of the growing risk presented by recent labor market weakness and the marked slowdown in hiring.
A brief shutdown of nonessential federal government services would be disruptive to many, particularly those federal workers who would be sidelined without pay. It creates a near-term burden both for furloughed government workers and those who are dependent upon various government services that impact most Americans to varying degrees.
The immediate effects may seem insignificant to most day-to-day activities for most Americans, but could be substantial in aggregate, particularly if they persist for an extended period. Even the Federal Reserve isn’t immune from the impact, as delays in economic data releases — such as the monthly jobs report or inflation readings — could complicate market analysis and cloud the central bank’s near-term decision-making.
However, the economic impact to a brief shutdown is unlikely to present a significant headwind to growth in the near term, even if it were to extend beyond a few days.
Market reaction: Investors resilient in prior shutdowns
Historically, markets have shown resilience in the face of shutdowns. That was the case again yesterday; equity markets opened lower but gradually improved over the course of the day. Equities may exhibit some volatility in the short term, as the standoff in Washington, D.C. plays out, but broad indexes such as the S&P 500 have generally held up surprisingly well during prior shutdowns and recovered quickly once funding is restored.
Treasury yields, however, could be more sensitive, as the markets recalibrate expectations to address the evolution of both short- and long-term implications. Will investors see the shutdown as clouding the near-term economic outlook enough to increase the risk of recession? Will the market-implied probability of additional near-term Fed rate cuts increase in response? Or will the shutdown remind investors of the growing divide in Washington, D.C. that increasingly complicates the legislative process and the conduct of the basic function of funding the government and/or raises questions about fiscal discipline and the long-term outlook for deficits and the federal debt?
Those are questions that remain unanswered at this time. It’s possible that investor sentiment may turn more cautious if the current shutdown extends for a longer period or is exacerbated by other factors that complicate the process of putting together enough of a bipartisan group of Senate lawmakers to pass a bill. A more protracted shutdown would, at some point, be more likely to weigh on investor sentiment. As noted, capital market reaction has thus far been muted.
What now?
Most importantly, we’d advise investors not to attempt to trade the news. While the ebb and flow of the debate could rattle markets, the strong likelihood is that a resolution is reached in the relatively near term. At some point, political pressure on both sides will likely lead to moderates eventually seeking common ground and an off-ramp to the impasse. The likelihood that the closure extends for a period long enough to result in significant, sustained economic damage still appears low. That doesn’t mean that it’s without risk, particularly given the already mixed message being sent by GDP, labor market data, and inflation.
For long-term investors, the key is to maintain perspective. Historically, shutdowns created short-term noise, but the fact that they’ve historically been resolved relatively quickly limited their impact on the overall trajectory of the economy or corporate earnings. Diversification, discipline, and a focus on long-term goals remain the best defense against policy-driven volatility. Understanding that the tone can change swiftly in Congress, particularly if behind-the-scenes negotiations create a breakthrough that could sway enough votes to get a deal done. That’s almost certainly a matter of when, not if, and will develop on a timeline that few outside of those actively engaged in the debate will know. Against that degree of uncertainty, investors should avoid making major changes to their investment strategy or portfolio positioning.
We’ll continue to monitor developments and weigh their potential implications related to portfolio decision-making. As always, please don’t hesitate to reach out to your relationship manager with any questions you might have.
