US: Snatching defeat from the jaws of victory

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US government shutdowns don’t necessarily affect the US stock market, or the country’s economy, negatively. But the political positions hardening faster than concrete, which caused this shutdown, may have a negative effect if there is a similar stand-off over the debt ceiling this month.

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Fighting instead of celebrating

As I write this, the US federal government is in a state of partial shutdown, which culminates a week of remarkable legislative strategic fumbling. At midnight on September 30, having failed to pass a budget or a continuing resolution to fund the national government, Congress forced closure of its non-essential operations. What constitutes “essential” is in the eye of the beholder; however, functions such as meat inspection, air traffic control and military operations in combat zones will continue without interruption.

Wrangling over defunding and delaying the enactment of the Affordable Care Act, also known as “Obamacare,” is the primary hang-up in negotiations. It was clear that hardening of positions by both parties would make an agreement on the budget difficult. But rational thinking held that given the country’s muted economic growth of late and its shrinking deficit, Congress would ultimately achieve a solution that averted the disruption a government shuttering creates. In retrospect, it was perhaps irrational to expect rationality from our public representatives. Any damage resulting from the closure will be entirely self-inflicted. The budget deficit has been quickly returning to the historic 3% level (Figure 1). Based on the numbers, Congress should be celebrating rather than fighting.

While disruptive, federal government closures are not without precedent. In fact, from 1976 through 1996, they were fairly common. During this period there were 17 episodes of budget battles leading to government closure. On average, shutdowns lasted roughly six days. The longest – from December 16, 1995 through January 6, 1996 – lasted 21 days and followed a five-day closure the prior month. The shortest shutdown lasted only one day and occurred in four instances.

The US budget deficit has been rapidly returning to 3%, thanks to sequestration and higher taxes.

A shutdown does not necessarily translate into lower equity prices. To wit: during the serial shutdown of 1995-96, the S&P 500 Index rose 6.55%. The impact of a shutdown on the economy is more difficult to assess. One estimate values the lost output at $300 million a day – or 0.002% of a roughly $16 trillion economy. So the impact, if the shutdown is short, will be limited.

The timing of the budget debate is extremely unfortunate as it immediately precedes the need to raise the debt ceiling under which the government operates. Currently at the statutory debt limit, the US Treasury has been deploying a series of “extraordinary measures” to continue paying the bills the government is incurring. But its ability to use these measures will be exhausted somewhere toward the end of October. Absent a willingness to negotiate and sufficient time to lick wounds created by the budget standoff, it is hard to see how Congress will reach a debt ceiling deal ahead of the late October deadline.

Trifling with the full faith and credit of the world’s reserve currency is serious business. What remains to be seen is if, this time, there will be consequences for bad legislative behaviour. When the US lost its AAA credit rating in 2011, no premium in interest rates was attached to sovereign script. In fact, the yield on the 10-year Treasury dropped from 2.56% on the day of the downgrade to 1.98% a month later. If an agreement on the debt ceiling is not reached, then a system of prioritisation will be enacted wherein the Treasury will decide which obligations are paid and which are deferred until the government’s cash flow or financing ability permits payment.

Given the roughly 20% rise in US equity prices this year on rather thin earnings growth and the realisation that the Federal Reserve will begin unwinding quantitative easing at some point soon, the state of play may make for rough sledding in markets while agreements are hammered out. To be sure, this will be an October to remember.