US Government Shutdown

Never take a hostage you are not going to shoot, and we will not for sure shoot this hostage!!

Tom Coburn, Republican senator, Oklahoma

Last week legislators decided to shut down all ‘non-essential’ government services (about a third of federal spending) rather than allow an enacted health law to take effect from the agreed date. Some 800,000 federal employees were likely to be sent home, this has now been qualified with 350000 civil defence workers returning to work. Goldman Sachs estimates that a week-long shutdown would shave 0.3% from GDP – not a game changer, but not insignificant either.Today’s news that the Republicans have agreed to raise the debt ceiling to allow for another month of negotiations is bitter sweet news. The ‘debt ceiling’ is due to be breached on October 17th, when US federal government borrowing will hit a staggering $16.7 trillion, the concession means the issue could now be pushed out to November 22nd.

The Republicans concession is sweet news in the short term as it highlights that they are looking for a way through the issue without pushing the world economy off a cliff. Markets will respond well to this. There is no guarantee however, that the Democrats will agree to such a short term concession given what is at stake. We will likely see a vote sometime Friday, US time.

The bitter side of the news is that the short term nature of the concession means that even with the Democrats support we will subjected to more stories of economic Armageddon for the another month. Also, markets will be unlikely to find any real direction until a longer term solution is negotiated, so in effect everything will be on hold.
The disagreement between the Democrats and the Republicans stems from the fact that the Republicans control the lower house and are vehemently opposed to President Obama’s new healthcare law (‘Obamacare’), whilst the Democrats have control of the Senate. Obamacare was signed into law in March 2010, having been approved by the Democrat-controlled House. Radical Republicans are now successfully preventing a vote on the budget in the House of Reps in an attempt to revise Obamacare. Over the last few years, several disputes have gone to the brink, including a potential government shut-down in April 2011.

Whilst Finsec Partners is normally particularly averse to excessive government spending of any kind, in this case we are sceptical of the Republican’s claims, principally because of the already significant inroads the US has made in deficit reduction. From a inconceivable level of 10% of GDP just three years ago, the US budget deficit is now under 4% and heading lower. Progress is being made. The Republicans argument is now less compelling.

What does this mean for Markets?

US government shut downs are not as rare as you might think; since 1976, there have been 17 such closures, lasting between 1 and 21 days. The financial markets have generally shrugged them off believing, like Winston Churchill, that the US government will do the right thing in the end, having exhausted all the alternatives. The average equity market movement over these various shutdowns has been a rise of 0.8%.

A failure to raise the debt ceiling for the longer term, has far more serious consequences as it would necessitate a sharp cut in spending; at worst, the US would default pushing America into another deep recession. Consequently, we believe, like the good Senator from Oklahoma, that a compromise is imminent and inevitable. Any serious shocks would result in blame landing squarely on the chin of the Republicans and opinion polls confirm this. Hence, we believe it highly unlikely that they will push the US over the cliff.

Far more encouraging than this rather puerile game of cat and mouse, is the significant progress being made by households, companies, banks and now the government in deleveraging; total US credit has fallen from a peak of 362% of GDP in 2009, to 330% today.
We are optimistic enough to believe that a much greater market-moving event will be the reduction in stimulus by the Fed, which we expect to begin in December. Whilst US interest rates are unlikely to rise before 2016, the massive QE tail wind will soon diminish. Watch closely, but no need to panic.