Highlights:
While attention is currently focused on the government shutdown, we believe the battle over the debt ceiling is a more important issue and a more significant potential risk.
Ultimately, we believe Congress and the President will be able to come to an agreement to raise the debt ceiling, but if they fail to do so, it would have dire economic and financial market consequences.
Investors should expect more volatility in the near term. While some investors have been becoming more defensive in this environment, for those with longer time horizons this volatility could represent a buying opportunity.
Additionally, we still expect real and nominal rates to rise over the next 6 to 12 months, but near-term risk aversion could spark a temporary pullback.
What are the risks of a government shutdown? What might happen if the debt ceiling is not raised?
Importantly, these are separate (though related) issues. Investors should distinguish between a short-term government shutdown and failure to raise the debt ceiling. While both issues are related to the ongoing budget debates in Washington, they have very different implications for the economy and markets.
Assuming yesterday’s government shutdown is temporary (meaning a couple of weeks or less) the economic impact at the national level is likely to be limited. The shutdown will modestly lower Q4 GDP and will probably lead to a short-term drop in consumer confidence. While this obviously comes at a delicate time (with the economy still struggling at below trend growth) the impact should be modest and temporary.
If the shutdown persists for longer, or if the political discord gets even worse, the hit to the economy would be greater. Specifically, a longer shutdown would (a) create more of a drag on the economy and (b) call into question Washington’s ability to reach a debt ceiling agreement.
Government shutdowns, while dramatic, have not been uncommon events over the last 40 years. However, debt ceiling breakdowns are unprecedented and are far riskier for the economy and markets. A failure to raise the debt ceiling before the October 17th deadline could put the U.S. in technical default, an event which would be massively disruptive to the economy and the global financial system.
Because a failure to raise the debt ceiling would be so damaging, we continue to believe that Congress will act prior to the deadline. Even if the government experiences a short-term shutdown, Washington should eventually stumble towards a solution to the debt ceiling dilemma.
What happens if the shutdown is reversed over the next day or two? Would that signal an “all clear?”
No. While a quick resolution to the shutdown would be a positive for the economy, and arguably for equities, the shutdown still represents less of a risk than the possibility of a debt ceiling breach. Even if a Continuing Resolution (CR) is passed, investor attention is likely to quickly turn to the debt ceiling. While we believe the debt ceiling will ultimately be raised and that the U.S. will avoid a default, history suggests that a compromise will prove elusive until the last minute. As a result, volatility is likely to remain elevated, even if a government shutdown is quickly reversed.
How should investors be positioned given these events?
Markets assume that a compromise over these budget issues will be reached, and while we share that view, this means that potential downside risks are not fully discounted. Even after accounting for Monday’s selloff in stocks, so far investors have not panicked. Stocks are down less than 3% from their recent peak and market volatility remains low. While volatility has been rising over the past week, the VIX Index (which measures implied volatility for equities) still remains below its long-term average. (The VIX closed Monday at 16.6, the long-term average is around 19, and the peak reached during the 2011 budget crisis was in the mid-40s.) In other words, investors should expect more volatility in the near-term as the potential risks are not yet fully discounted into stock prices.
For those investors who have not already adjusted their portfolios for a higher volatility environment and who wish to do so, they may want to consider getting a bit more defensive, possibly raising cash. In contrast, those with longer time horizons can probably use the market angst around the U.S. budget issues as a buying opportunity. However, in the unlikely event that Washington fails to raise the debt ceiling, stocks would likely suffer a much more pronounced pullback. Under that scenario, the only asset class that is a clear beneficiary would be gold.
While we continue to believe that rates (both nominal and real) are likely to rise over the next 6 to 12 months, a shutdown and/or a contentious fight over the debt ceiling may temporarily reverse that trend. To the extent we see further selling in equities and other risky assets, investors may continue to look to Treasuries as a safe-haven, pushing prices higher and yields lower.
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