Should I worry about the government shutting down (again) or defaulting on its debt?

You would think we’d get used to this by now, as many Americans have grown tired of these congressional battles—which they view as petty and unnecessary.  You might wonder why we choose to spend any time at all on political items like this relative to our usual discussions of the economy and investment markets.  From an economic standpoint most directly, government expenditures represent 20% of GDP and a government shutdown would directly affect Federal government discretionary spending, which represents almost 40% of non-interest expenditures.  A few days of closure wouldn’t do a lot, but a few weeks might make a dent.

Unfortunately, perceptions of these events can also have secondary effects.  They can trickle down to lessened certainty about forward-looking prospects about the economy (legitimate long-term fear or not), which can potentially erode overall sentiment about business and job prospects, which can suppress private spending, which can hold back corporate revenues, which can pressure profits, which can hold back economic growth.  You can see how a negative feedback loop can easily begin if sentiment surrounding such issues becomes too negative, which is why economists pay attention to things like this.

Many Washington experts view the recent round as a political repeat of what’s been happening on almost a continuous basis.  During a recent conference call we happened to sit in on, a political analyst at Fidelity noted that the ‘system is broken and participants are flawed,’ which we think echoes much of Main Street America’s opinion (bolstered by anecdotal comments advisors share with us from clients, some of which colors their investment views).

Without getting into procedural minutia, there are a few elements critical to the current debate.  One is more immediate (as in today, Sept. 30, the last day of the government fiscal year), when the continuing resolution that kept the Federal government running comes to an end.  A resolution stop-gap had to be put in place since a budget wasn’t officially passed last year.  If nothing is passed today, like a new resolution or full budget, the government shuts down due to lack of funding.  This isn’t unprecedented—it happened most recently for a total of 28 days in Dec. 1995-Jan. 1996 during the Clinton vs. Gingrich political battles—but has actually happened 17 times since 1976, ranging from 1 to 21 days in a stretch.  It also won’t stop the Earth from rotating, but can lead to more hard feelings and even less confidence in government, which of course can trickle down to markets as noted above.

The debt limit debate is similar to the same one we went through in the summer of 2011, and that wasn’t pretty.  This comes up Oct. 17 and is much more serious.  The government needs to issue debt to fund itself, but runs up against periodic statutory limits, which must be increased routinely to keep the money flowing (since the restriction was put in place in the early part of the 20^th century, the limit has been raised over 100 times…so was almost a routine matter previously).  But it has become huge deal under a contentious Congress, who has used this as a pawn for other issues.

While no side wants a default and all appear to see the obvious repercussions of a default (or even the hint of one, based on negative reactions two years ago from credit rating agencies towards U.S. debt, which led to market turmoil), both parties have dug in their heels.  Naturally, Obamacare, which is the grand achievement of the administration and detested by Republicans, is being used as a trump card—Republicans would love to take away its funding if possible, effectively rendering the law ineffective.

There a lot of moving parts to these two issues that are simply not ‘modelable’ in a traditional investment framework.  However, considering the stakes, consensus views point to a workable outcome of some sort that will keep the government running (or, at worst, minimize the shutdown time), although the probability of agreement has fallen over the course of the weekend.  Shutting down for an extended period of time is unlikely, but of course possible.  However, that wouldn’t help an already anti-Washington tone around the country.  Related to this, one of our favorite quotes comes from Oppenheimer Funds chief market strategist Jerry Webman, who reiterates “Hating one’s government is not an investment strategy.”

We would have to agree.  But, due to uncertain outcomes in the shorter-term clients probably can’t be reminded too often about the benefits of a diversified portfolio—where both stocks and bonds may act quite differently from each other during such periods (as in 2011), and differently than one might first expect.