Market Commentary - 10.03.13

The Malfunctioning U.S. Government

The U.S. government is in a shutdown. According to “Google,â€쳌 a shutdown is “a closure of a factory or system, typically a temporary closure due to a malfunction or for maintenance.â€쳌 Based on this definition, when we look at what has transpired in Washington, it’s clear that there’s a malfunction in the government. The two primary political parties are involved in another fiscal fist fight over federal spending, the debt ceiling and, indirectly, The Affordable Care Act (also referred to as ObamaCare). Beginning on October 1st, for the eighteenth time since 1976, Congress’s inability to pass a budget and fund government operations has resulted in the shutdown of non-essential government operations. Despite fairly lame overtures by both parties to come to some type of agreement, the primary issue at hand is ObamaCare. The Republicans wish to delay, alter or repeal President Obama’s hallmark initiative, while Democrats have asked for budget talks to continue without strings attached.

Washington pundits can only guess how long the current impasse will last, but since 1976, using history as a guideline government shutdowns have ranged in duration from one to 21 days. This stalemate could certainly harm the economy if it does not end soon. In the short term, we believe a government shutdown would have minimal economic impact. However, a longer lasting impasse would begin to reduce fourth quarter economic growth.

According to Capital Economics, the furloughing of 800,000 federal employees, as part of the government shutdown, will reduce spending by roughly $155 million per day. Over an entire year, the cost would be equivalent to about 0.3% decline in GDP, which is not ideal, but is manageable. Of course, the drop off in Federal spending is more than just the suspension of salary payments to employees. Based on last October’s government spending, Capital Economics believes that total spending in "non-essential" departments (including employee salaries) was roughly $95 billion, which is equivalent to 6% of GDP on an annualized basis. That may be a worst case scenario. The actual decline in spending will likely be much smaller than that, perhaps 1% to 2% of annualized GDP. However, regardless of the actual financial effect of the shutdown, it will impact the currently fragile U.S. economy and, consequently, the stock and bond markets.

While the government shutdown is a reality, is it just an appetizer for the main meal? While government shutdowns have unfortunately become somewhat common, investors are more concerned with the needed extension of the U.S. Government debt ceiling, set to be reached on October 17th. If a resolution is not found, beginning in the second half of October, the economic and market impact of the impasse would become much greater. In particular, the Treasury would not have enough cash on hand to make a scheduled Social Security payment of nearly $25 billion on November 1st. It would also be unable to meet a debt interest payment of roughly $30 billion that will fall due on November 15th, potentially triggering a default. The ramifications would be huge – potential downgrades by ratings agencies, elevated levels of market volatility, and a worsening economic situation. Furthermore, what cannot be measured is the indirect effect from businesses. With uncertainty in Washington and its potential effect on the economy, businesses leaders may be reluctant to increase capital expenditures or hire additional workers – both clearly not a good sign for a still fragile economy.

Overall, we are entering a potentially volatile period for the financial markets. Increased uncertainty combined with below-trend economic growth will likely lead to sharp market fluctuations. To mitigate the risk of volatility, we remain committed to increased diversification. Within equities, we would begin reducing exposure to U.S. stocks and instead focus on better areas of opportunity – international developed markets. Within fixed income, we would maintain a bias toward spread product, such as corporate bonds, which generally pay a higher yield compared to similar Treasuries.

This information compiled by Cetera Financial Group is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

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