2013 Government Shutdown

As we begin the week, the Federal government has been shut down for the 18th time in U.S. history and the first time since 1996. Over the weekend, Congress was unable to agree over funding the Federal government into the 2014 fiscal year, which begins today. As a result, some Federal government services will be interrupted, and roughly 800,000 Federal employees will be furloughed. This is the first of two significant fiscal fights expected in Washington this month, the second being the debt ceiling – the statutory limit on the amount that the federal government can borrow.

The Situation

It has been many years since Congress actually passed a budget bill, so the federal government has been operating based on a series of Continuing Resolutions (CR’s) – the most recent of which expired at midnight last night. A CR ‘continues’ the government operations at last year’s spending level. House Republicans have so far tied continuing the funding of government operations to a delay in implementing the Affordable Care Act (ACA or Obamacare). Senate Democrats and the President have been adamant that ACA is not something they are willing to negotiate over, and have so far rejected each of these bills.

Funding the Government

Without a new CR, the federal government has lost authority to spend money, and most non-essential services were suspended this morning. From a purely functional standpoint, this isn’t as bad as it sounds. Military, border security, air traffic control and food inspections, to name a few, are considered essential services and will continue. Social Security checks and Medicare benefits will continue to be paid, for example, but new applications or disputes involving current benefits will not be processed. Postal services should not be affected as they are not funded by the government.

That said, we don’t want to trivialize the impact. 800,000 Federal employees will stop working, and it’s not clear if or how many of the roughly 1.3 million who remain on the job will even be paid. While the 1.4 million active duty military will be paid, that still leaves 2.1 million workers without paychecks until this is resolved. If that resolution happens fairly soon, the economic damage is likely to be minimal. If it stretches on for more than two or three weeks, we’ve seen estimates that it could shave 0.2-0.7% off of economic activity. This is not just from the impact of delayed wages, but the knock-on impacts to businesses that contract with the federal government and those who serve federal workers, such as restaurants, hotels near national parks, etc.

The greatest impact will be on hourly workers. This is not trivial, but still manageable from an economic standpoint. The markets are likely to become more volatile (the Dow was down sharply yesterday) the longer this continues, but the relatively muted reaction so far suggests investors are not expecting this to stretch on for long.

The Debt Ceiling

This is a much bigger problem. The Secretary of the Treasury has indicated the federal debt limit will be exceeded sometime around October 17. It’s not yet clear whether the House will link raising the debt ceiling to changes to Obamacare. If Congress does not act to raise the debt limit, the Treasury would not have enough cash on hand to make all of the payments required, including federal employee salaries, Social Security payments, vendor payments, or interest payments on the debt. Failure to make interest payments on Treasury and other obligations could create a technical default on U.S. debt, which has the potential for very significant global consequences.

The political calculations here are much harder to predict, and as a result, any sense that Congress or the President are ‘playing chicken’ with defaulting on the national debt is likely to be much more disruptive. The last time there was a serious dispute over the debt ceiling in 2011, the S&P 500 dropped 19% as investors grew increasingly worried that political leaders would cause a default on U.S. debt. Also, the U.S. credit rating was downgraded a half-notch by S&P. The markets recovered quickly, but there was real financial and economic damage caused by the brinksmanship, and it took a long time for business and consumer confidence to rebound.

A Thin Silver Lining

In a really perverse way, the current thinking seems to be that the government shutdown today improves the odds of a negotiated settlement dealing with government funding and the debt ceiling by October 17. By drawing a line in the sand at government funding, the Republicans have left room to negotiate a compromise around spending cuts and government funding without actually risking default on the Treasury debt. We believe this has mitigated some of the impact of the drama around the budget negotiations today, but we are probably headed for a period of increased headline risk and market volatility.

We obviously do not know how this will play out, but our portfolios are positioned fairly defensively, which should help to mitigate the impact of the current impasse. We are also reasonably confident that our political leaders will eventually do what is necessary. However, the longer it is delayed the more uncomfortable investors will become; this will be reflected in increased market volatility. If Congress can put together a resolution without spooking investors and threatening default on the national debt, then there should be no lasting impact. That said, the last time Washington engaged in this kind of brinksmanship, it took a significant sell-off in the stock markets to remind politicians that they were playing with fire. We certainly hope they will recall that lesson and won’t need a fresh reminder.