Another Government Shutdown Looms

The melodrama continues in Washington as we face the specter of another government shutdown. The new fiscal year for the Federal Government starts on October 1^st. This is the 22^nd government shutdown in the last fifty years.

In theory, under a government shutdown, non-essential federal functions are suspended. Systems including health programs, Social Security and Medicare, SNAP benefits, Food and Drug Administration inspections and small business loans could be affected.

^{Source: U.S. House of Representatives; Note: Shutdowns are attributed to the year in which they started; Chart: Erin Davis/Axios Visuals. Data as of 10/02/2023. Chart illustrates length of US Government shutdowns.}

A resolution by some House Republicans to extend the deadline a month was ignored by Democrats and even some Republicans.

According to Strategas Research, the government has had 20 shutdowns that occurred during times when the stock market was open. The average length of those shutdowns was about 8 days. The most recent which started in late 2018 and lasted into 2019, was the longest at 34 days.

Thankfully, the stock market has seen this before most of the time shrugging off the gridlock in Washington as par for the course. To put an exclamation point on that, the S&P 500 returned a whopping 10.3% during that 34 day ‘record’ shutdown.

Over all shutdowns, the S&P 500 has returned, on average, +0.04%.

During the most recent government shutdown drama (they reached a settlement before a shutdown occurred), the market zoomed once a resolution was reached.

On May 30^th of this year (seems like so long ago), another government shutdown loomed. A last minute deal was reached to increase the debt ceiling for two years. The agreement also set limits on annual appropriated spending – one on defense, and one for non-defense items, for fiscal 2024 (starting next month).

What happened was that the all 12 appropriation bills got stuck in conference because the House and Senate split. At that point, the two chambers are supposed to forge a compromise, which goes to a vote in each chamber before going to the president.

In prior instances, the House could pass a continuing resolution to continue to fund the government. However, the Fiscal Responsibility Act (a classic example of naming a bill the opposite of what it actually does!) had certain features meant to discourage congress from using continuing resolutions beyond December.

If something isn’t done by January 1^st, then spending limits would be automatically revised on all the appropriation bills with a particularly large cut to defense spending.

Could A Shutdown Be A Good Thing?

Typically, a shutdown is viewed negatively by the market and public as it is an indication of ineptitude and lack of compromise among our leaders. However, since 2020, fiscal spending has gotten out of hand.  In the past year alone, approximately 2 trillion dollars was spent more than came in.

^{Source: Committee for a Responsible Federal Budget, U.S. Department of Treasury, Congressional Budget Office. Data as of 10/02/2023. Graph illustrates U.S. budget deficit.}

Spending can be broken down between fiscal and monetary policy. Fiscal is controlled by the Federal Government, mainly Congress, while monetary policy is controlled by the Federal Reserve. The Fed has been reducing their balance sheet but at the same time congress has not stopped their profligate spending.

Given the truly massive amount of debt and debt in relation to total GDP, the public may actually push for spending cuts. In the years following the 2010 government shutdown drama, a ‘sequestration’ was enacted in the Budget Control Act of 2011 (“BCA”).  

The sequester was an across the board spending cut as part of the broad deficit reduction package. This action but more than $1T in future spending (over the subsequent ten years). This is essentially what the country is needing now. Broad, sweeping, across the board cuts to all government spending.

The reason being interest rates are no longer at zero. So the US Government now has to pay interest expense again. No more free money!

This fiscal year, interest expense could top $1 trillion. Check out this statistic. Interest expense on government debt is up 242.5% of what it was just 18 months ago.  

The current situation risks getting out of hand and becoming a debt spiral. This is the relationship between government debt and interest rates, the cost to finance that debt. The most debt, the treasury bonds they must sell. The more bonds they sell, the more they risk upsetting the demand/supply balance. If that becomes skewed, the interest rate demanded by the market will rise. As that rises, the interest expense that the government must pay to service the debt will rise, further deteriorating the fiscal picture.

A spiral ensues.

^{Source: Congressional Budget Office, The 2023 Long-Term Budget Outlook, June 2023, The Budget and Economic Outlook: 2023 to 2033, February 2023, and The Budget and Economic Outlook: 2020 to 2023, January 2020. Data as of 10/02/2023. Graph shows national debt as a percentage of GDP.}

The federal deficit is projected to grow from 5.9 percent of GDP in 2023 to 10.0 percent in 2053. That outpaced spending combined with slower economic growth will make it more challenging to reduce the national debt in proportion to GDP in the future than it was in the decades following World War II.

Much of the recent rise in interest rates, I believe, is due to the government shutdown potential and the deficit problems this country faces. If the government representatives come together and realize the fiscal problems we face are significant and act on it, we will likely see interest rates fall.

Lower interest rates will be highly supportive for risk assets – especially  long-term bonds.

Here is a list of government functions that still operate during a shutdown:

• Social Security
• Medicare
• Medicaid
• Most veteran’s programs
• Military operations (including Ukraine)
• Diplomatic missions
• US Post Office
• Law enforcement
• ‘Essential’ government services

^{Source: Insight Investment, as of 10/02/2023. Chart illustrates Pull to Par relationship.} 

As always, we appreciate the trust you place in us.

Mark J Asaro, CFA