Will a Government Shutdown and Debt Ceiling Crisis Rock the Equity Markets?

President Trump has made it clear that if the Congress doesn’t give him the money to build his pet project – a wall along the border – he will not sign any bills. If this impasse is not sorted out by September 30, it will end up in double chaos.

Key points

  1. We have a stalemate between the Congress and the US President
  2. Stock market’s performance has been mixed during debt ceiling crisis and government shutdown
  3. The debt ceiling crisis in 2011 was followed by a credit rating cut, which led to a huge correction in the equity markets
  4. Goldman Sachs sees only a 35% probability of a government shutdown
  5. We believe that the equity markets will not remain sanguine if an agreement is not reached in time

The US economy will have to face the consequences of a government shutdown and fears of some kind of default for failing to raise the debt ceiling on time. Let’s see how these events have influenced the stock market in the past and will history repeat itself this time?

What is a government shutdown and a debt ceiling?

In simple terms, debt ceiling is the limit on the amount of debt that the US Treasury can issue for financing various government expenditures. If the debt ceiling is not raised in time, the US Treasury has to resort to “extraordinary measures” to fund government expenses. However, if the situation drags longer, it can even lead to a default, a catastrophic event for the economy and the equity markets.

The United States Constitution has empowered the United States Congress to appropriate funds for government operations. The appropriations bill is first passed in the House of Representatives and then by the Senate after which it is sent to the President who either signs the bill or ignores it. Under both conditions the bill becomes law.

However, if the President vetoes the bill, it is then sent back to the Congress, which can override it with a two-thirds vote. Nonetheless, if both the Congress and the President fail to sort out the logjam, the government will have to shutdown non-essential operations and obligations for paucity of funds, sending thousands of federal employees on furlough.

How many times has this happened in the past?

US Government shutdown

Most of the government shutdowns prior to 1980 were confined to the political circles because the federal employees continued to work and were paid retrospectively when an agreement was reached. However, in 1980 and 1981, the then-attorney general Benjamin Civiletti gave his legal opinion that the government work has to stop until Congress agrees to fund it.

Since then, there have been 12 shutdowns. The longest was from 15 December 1995 to 06 January 1996 that lasted 21 days. The last shutdown was in 2013, from September 30 to October 17, lasting 16 days during President Obama’s tenure.

Debt ceiling crisis

The Wikipedia has listed 87 instances of debt ceiling changes since 25 June 1940. On most occasions, there was no major damage to the economy, however, the 1995 debt ceiling crisis led to the longest government shutdown in the US history.

The crisis in 2011, though resolved at the 11th hour, led to a credit rating downgrade of the US for the first time by the credit-rating agency Standard & Poor’s from AAA to AA+. Similarly, during the debt ceiling crisis in 2013, credit rating agency Fitch Ratings placed the US under a “Rating watch negative”.

How did the various markets respond during the previous two debt ceiling crisis?

Source: Seeking Alpha

Leading to the previous two debt ceiling crisis, the stock markets fell in 2011 but rose is 2013. On the other hand, the US dollar fell marginally, whereas, the Treasuries rallied during both occasions.

However, that is only half the story because, in 2011, the markets fell sharply after the debt ceiling crisis ended because of the S&P credit rating cut. However, in 2013, the markets continued their journey northwards even after the crisis ended.

Similarly, during government shutdowns, the equity markets have been mixed. Nevertheless, on an average, they have fallen 0.6% over the period of the closure, according to LPL Financial.

Source: Market Watch

This shows that the government shutdowns have not materially affected the stock markets. So, will the current deadlock also be uneventful for the equity markets?

What is likely to happen this time?

The economic situation and the political backdrop during every shutdown or a debt ceiling crisis is different. Let’s see some expert opinions this time.

Goldman Sachs, which two weeks back had given a 50% chance of a government shutdown has reduced it to 35%, following the catastrophic storm Hurricane Harvey. Goldman believes that no political party will want to own the blame of obstructing federal relief works underway, hence, the change in forecast.

Analysts at Morgan Stanley, however, are of the opinion that a solution will neither be easy nor smooth. According to them, a sharp fall in the markets may be needed to pressurize both sides to arrive at a compromise.

Isaac Boltansky, director of policy research at Compass Point Research & Trading in Washington said, “I think this time will be worse because of the uncertainty from President Trump,” reports The New York Times.

However, a few others maintain that both the issues will turn out to be a non-event for the stock market. Most shutdowns “don’t last long and equities rarely see a large sell-off,” wrote Ryan Detrick, senior market strategist at LPL Financial in a report on Thursday, reports CNBC.

We expect the markets to fall this time if timely action is not taken

The stock markets have risen sharply since the US Presidential elections of last year on hopes of tax reforms and higher fiscal spending. Also, both the bull market and the economic recovery cycle are on its last legs and a dip is likely, if history is any guide. However, as the bull market progresses, the market participants become complacent. This time too many believe that a compromise will be reached in time.

However, if the President and the Congress fail to arrive at a compromise in time, traders will start to question the possibility of any meaningful tax reforms going through. This will lead to a dent in confidence, which is likely to lead to a sharp fall.

On the other hand, if the political parties show a united front and find a middle path, it will be a morale booster and the equity markets are likely to rally to new lifetime highs.

Therefore, the current gridlock will move the markets one way or the other.

Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.