Volatility in the financial markets picked up this week as all eyes were on the U.S. government shutdown. Although, the S&P 500 finished the week flat, and U.S. Treasuries sold off slightly, bringing the 10-year note up to 2.65 percent from 2.62 percent from the prior week. Because of the government shutdown, many significant economic data points will not be released, including important employment statistics, which the Federal Reserve monitors closely for signs of an improving economy.
Friday marked the fourth day of the government shutdown, and historically these shutdowns have lasted anywhere from one to 21 days. Nonetheless, some focus should shift away from commotion out of Washington to the kick-off of third-quarter earnings season this week.
Drama erupted in Washington once again as “non-essential” parts of the U.S. government have been shut down since October 1. Approximately over 800,000 public sector workers will be furloughed until further notice. However, we’ve been down this road before. Ironically, this is the 17th government shutdown in the last 40 years, and the most recent shutdown was 17 years ago! What caused the shutdown and what will this mean for the markets, our portfolios, and our clients?
The Patient Protection and Affordable Care Act created gridlock, as the new health care law took effect October 1, the same day government funding was scheduled to expire. House Republicans used the expiration of government funding as leverage to make changes to the healthcare bill, as well as changes to other entitlement programs. President Obama, however, says he refuses to negotiate under threats, and he will only be open to negotiation after Congress has funded the government and raised the debt ceiling.
What are the effects of a government shutdown? Due to the 800,000 – plus public sector workers who will be temporarily without pay, this will likely hurt consumer demand in the short term, which could affect corporate profits. Historically, however, a government shutdown has had minimal impact on the financial markets, again, at least in the short term.
The much bigger fear resulting from this spar between House Republicans and President Obama is that Republicans will use this leverage to negotiate more spending cuts to entitlement programs before they agree to raise the debt ceiling. The deadline to raise the debt ceiling is only days away, and on October 17, if the debt ceiling is not raised above the current $16.7 trillion, the government will run out of money to pay its bills and default on its debt. The historical probability of a U.S. Treasury default is zero. It’s never happened before. That doesn’t mean that it couldn’t happen now, however.
We know from history that a government shutdown will have a minimal effect on the markets, and we can infer that a U.S. credit default could create another financial crisis. Fortunately, if we use history as a guide, the probability of the Congress allowing the U.S. to default is slim. The drama unfolding each day on the news will likely create much more volatility in the markets in the coming weeks or months. So, how will this affect CLS’s portfolio positioning and ultimately affect our clients?
As the recognized behavioral and value investor James Montier, would say, if you aren’t certain what the future will hold, you shouldn’t position your portfolios as if you do. In other words, CLS is not positioning portfolios for a major catastrophe to occur. In fact, we will be looking for opportunities to add to securities that we believe will have greater return potential for our clients.