The Impact Of A Potential Government Shutdown And The Snowball Effect

The federal government is nearing its fiscal year-end on September 30, 2023. This means all eyes are on Congress as they scramble to pass the annual appropriation bills that fund government operations. Failure to do so prior to the start of the new fiscal year would trigger a government shutdown.

While developments have been fluid over the past few days and are likely to be even more so in the days ahead, the current path has been insufficient to stave off a shutdown on October 1. Here’s what investors need to know about the potential government shutdown and its impact to bond and equity markets.

What Is A Government Shutdown?

Despite its name, a shutdown doesn’t necessarily mean the complete ceasing of government functions. Employees that perform essential functions, for example, are still required to work. The caveat is that they aren’t paid until there is a resolution.

Most other federal employees, however, are instructed not to report. And this can create significant disruption. Important services, such as passport processing for travelers and loan origination for small businesses, could be delayed indefinitely. Visitors to the national parks could also find the visitor centers and bathrooms closed.

It’s important to note that shutdowns don’t affect the flow of Social Security and Medicare payments, nor do they affect the ability of the Treasury to pay interest on outstanding debt. This is due to the fact these payments are outside of the 12 annual appropriation bills that must be passed each year.

Why May The Government Shutdown?

The failure to enact these appropriation bills, absent a continuing resolution, is the core reason the government shuts down. A partial shutdown can also occur if some but not all the bills are enacted. In this case, only agencies without appropriations would be forced to shut down.

This year, there is a risk of a partial shutdown at the end of this month, as there are 11 spending bills that are outstanding in the House of Representatives. Deep-seated disagreements within the chamber on party-line issues have led to contentious negotiations in recent days, so much so that the party was sent home over the weekend by House Speaker Kevin McCarthy.

Economic Considerations If Government Shuts Down

The last government shutdown was in December/January 2018-2019. Though a partial, it lasted 34 days and resulted in an estimated +$3.0B in lost GDP, according to a report from the Congressional Budget Office. While that sounds large, it represented just 0.02% of projected annual GDP in 2019.

The shutdown’s impact on overall growth, therefore, is likely to be minimal. Other economic measures, however, may attract more attention. One is employment data. The government has been one of the top employers this year in terms of job additions, just behind education/health services and leisure.

One could expect a dip in the data in the first measurable period following the shutdown, though the temporary nature of the shutdown would make this fleeting. Similarly, the fact that agencies and staff would receive their full backpay once the budget is ultimately approved is another reason the economic impact would likely be muted.

From a business standpoint, the big risk stemming from a shutdown is simply uncertainty. While past shutdowns have been short-lived, about eight days on average, no one can ever predict how long a shutdown will truly last. The most recent shutdown in 2018/2019 was the longest, at just under 40 days. With the political temperature even higher in the present, there is a risk of a prolonged closure.

Sectors To Watch During Government Shutdown

A prolonged shutdown could impact certain sectors harder than others. Those centered around travel and leisure would be the first to come to mind. If travelers encounter delays in having their documents processed, they may be forced to abandon or forgo their trip altogether. The prospects of a looming shutdown could even be steering some away from making plans for future trips.

Officials at the White House warned this week that there could be long lines at airports, among other disruptions. This would compound existing problems relating to the shortage of air-traffic controllers. Airline stocks, therefore, would be one group to watch as the week progresses. Names, such as Southwest Airlines (LUV), are already trading at or near their 52-week lows. I’d expect further declines in the event of a shutdown.

Hotel stocks are another group to watch. If travelers put off or cancel their plans, this group invariably would be impacted. Aside from the traditional names such as Marriott International (MAR) and Hilton (HLT), investors could also look to Airbnb (ABNB). While the shares have all held up over the past year with market beating returns, I would view the group at risk of downside, barring resolution in Congress.

How To Invest If Government Shuts Down

In my view, staying the course is the most practical way of trading any government shutdown. While the disruptions in services and the negative impact on federal employment levels will certainly grab headlines, one should remember that the average shutdown has historically lasted just over a week. A week’s worth of disruption doesn’t warrant significant changes to a long-term portfolio.

For investors who nevertheless still seek a net of safety, I continue to favor U.S. Treasury bonds and elevated holdings of cash and equivalents. Bonds are especially attractive, given current yields. Even more, unlike during debt ceiling standoffs, coupon payments aren’t at risk during shutdowns, as interest obligations are still paid on their regular schedule.

My Prediction

In the week ahead, market volatility is likely to increase with each passing day without a resolution to the current standoff. U.S. stock indexes were already under pressure this past week following the Federal Reserve’s signal that they may not be done raising rates. The current uncertainty in Congress could compound these downward pressures.

While it’s likely to be messy, I expect the fractious chamber to reach a last-minute agreement. And in a worst-case scenario, where an agreement isn’t reached, headline-grabbing disruption in services would be expected, but a prolonged closure more than the historical average of about a week would not.

Though contentious, past standoffs have always proved temporary, with little lasting impact on U.S. equity markets. Just the same, the current gridlock is likely to stay on trend.