Impact of U.S. Government Shutdown on the Economy and Financial Markets

By the Curmudgeon

Threat of U.S. Government Shutdown Looms Large:

U.S. President Donald Trump refused to meet with Democrats this week to discuss a compromised spending plan to avoid a government shutdown, which is now likely to start at midnight on September 30^th. Trump said earlier this month that Republicans should not “even bother” negotiating with Democrats and suggested his party could fund the government solely with Republican votes.

On Sunday afternoon, sources told CNN that Trump will meet with top congressional leaders from both parties tomorrow. He canceled an earlier sit-down with Democrats and has called their demands, which center primarily on health care policy, “totally unreasonable.”

In a CNN interview on Sunday, Speaker Mike Johnson said that the president was “always open to discussion.” But when pressed on whether Trump intended to negotiate a deal, Johnson sidestepped the question and accused Democrats of holding government funds hostage for “partisan demands.”

So even though leaders of both parties agreed to a Monday meeting, it was unclear whether President Trump intended to reach a bipartisan compromise or if he was summoning Democrats to press them to accept Republicans’ funding proposal.

Republicans have only a narrow majority in the Senate, so passing a government spending bill that can obtain the necessary 60 votes depends on attracting at least a small amount of Democratic support. That will require bipartisan negotiation, an art that has been fading steadily on Capitol Hill and seems to be lost forever during President Trump’s second term.

“The way this country works, you’ve got to sit down with people you may not agree with and come to an agreement, come to a negotiation,” Senator Chuck Schumer of New York, the Democratic party minority leader, said on Tuesday after Mr. Trump canceled their meeting. “Donald Trump is not a king. He’s the president, and he has his responsibility to work to avoid the Trump shutdown, and time is of the essence.”

If Congress fails to approve funding for the government by the beginning of the next fiscal year on October 1st, thousands of federal employees will face furloughs, with Trump threatening widespread layoffs. While critical services such as Medicare, Social Security, air traffic control, postal operations, and military functions would continue, most other federal activities would come to a halt. But not the Federal Reserve Board, which is self-funded and doesn’t depend on Congressional appropriations like most federal agencies.

Shutdowns vs. Debt Ceiling Crises:

It is important to differentiate between government shutdowns and more dangerous debt ceiling crises.

l Government shutdowns: These are domestic political disputes that primarily impact U.S. government employees and residents, not foreign bondholders.

l Debt ceiling crises: These are far more serious global events. Failure to raise the debt ceiling risks the U.S. government defaulting on its debts, which has already impaired the nation's credit rating and could damage the global economy.

Economic Impact of a Government Shutdown:

Given the current political environment, a government shutdown, even if initially not alarming, could become prolonged and difficult to resolve. A lasting shutdown could negatively affect the economy, weaken federal agencies through layoffs, and worsen the nation's political divisions.

Here are the potential effects of a prolonged government shutdown:

A lengthy shutdown could diminish consumer and investor confidence. Historically, shutdowns have led to a loss of economic output. For instance, the Congressional Budget Office (CBO) estimated that the 2018–2019 shutdown reduced GDP by $11 billion. The longer a shutdown lasts, the greater the economic consequences.

Mass layoffs and furloughs could cause severe disruptions to federal government agency operations. If federal employees leave for other jobs, it could lead to a loss of institutional knowledge and leave some agencies permanently understaffed and unable to function effectively upon reopening.

Worsening political divisions: In today's highly polarized climate, a shutdown could escalate existing political tensions. Spending bills are often used to score political points, and a funding standoff could become a flashpoint that deepens divides rather than resolves them.

Delayed services: Essential services like Social Security and mail delivery generally continue, but discretionary services can be delayed or stopped entirely. A prolonged shutdown could lead to backlogs in crucial services such as food inspections, loan processing, and immigration hearings.

Public trust and uncertainty: Frequent or prolonged shutdowns and the brinkmanship surrounding them erode the public's trust in the government's stability and reliability. This uncertainty can also hinder business and investment decisions.

Historical Effect of Shutdowns on Financial Markets:

While disruptive and painful for those directly affected, government shutdowns have had minimal impact on the overall economy and financial markets, according to analyses by Vanguard and JPMorgan. This is in contrast to much more serious debt ceiling crises.

l Using data from the Congressional Research Service and FactSet, Vanguard tallied 21 government funding gaps of one kind or another since the mid-1970s. Vanguard’s analysis of seven shutdowns lasting at least 10 days found mixed results for the S&P 500, with declines in four instances and gains in three. The worst drop was -4.4% in 1979, while the best gain was 9.3% during the 2018–2019 shutdown.

l JPMorgan Wealth Management found 14 actual shutdowns of one day or more. The longest and most recent lasted from Dec. 21, 2018, to Jan. 25, 2019. JPMorgan examined foreign exchange markets, in addition to the stock and bond markets, during shutdowns since the 1970s. The asset management firm drew the same conclusion. “Government shutdowns have had limited impact on financial markets.”

While the overall economic impact is limited, shutdowns do cause temporary damage. For example, the five-week 2018–2019 shutdown slowed GDP growth by 0.1% in late 2018 and 0.2% in early 2019, according to the Congressional Budget Office.

A 2023 forecast by Goldman Sachs estimated a reduction in economic growth of 0.2 percentage points for each week of a potential shutdown, though these effects were expected to be temporary and offset by a later economic rebound.

Financial Markets Yawn:

The rising risk of a government shutdown has been obvious for weeks, but there’s been minimal market reaction. Since the Federal Reserve has resumed its long-delayed interest-rate reductions, and with corporate profits still rising and capital expenditures on artificial-intelligence (AI) infrastructure growing exponentially, the U.S. stock market’s upward momentum remains intact.

While U.S. stocks have risen, U.S. government bond prices have declined slightly (rates higher) since the Fed’s 25bps rate cut on September 17^th.

The VIX index is recognized as the world's premier gauge of U.S. equity market volatility. As of Friday’s close, it stood at 15.29, which was 21.1% below its YTD moving average of 19.38. That implies little or no fear of lower stock prices even if there is a prolonged government shutdown.

Current Stock Market Valuation:

As we’ve noted in numerous Curmudgeon posts like this one, the U.S. stock market continues to be by far the most overvalued in history. The chart below shows Hussman Advisers most reliable gauge of market valuations in data since 1928: the ratio of non-financial market capitalization to gross value-added (MarketCap/GVA).

A graph showing the stock market

AI-generated content may be incorrect.

Conclusions:

The mounting, overlapping crises that characterize the second Trump administration have created major uncertainties for businesses large and small. The challenges include higher costs and operational uncertainty caused by tariffs and trade wars, policy shifts affecting specific sectors, such as clean energy and finance, and potential worker shortages from tighter immigration policies.

A government shutdown would create more challenges for the U.S. economy, including disruptions to federal contracts, delays in loans, and negative impacts on consumer confidence and spending. The severity of those challenges depends on the duration of the shutdown. A long shutdown, coupled with other domestic concerns and geopolitical crises, could set off market volatility that most investors don’t expect (see VIX discussion above).

End Quote:

It’s tempting to believe that because the AI induced stock market bubble has not yet burst, it must not be a bubble, and if it is, it must be immune to bursting. PhD economist and fund manager John Hussman relates that belief to the “The Inelastic Market Hypothesis.”

“In a nutshell, this is the idea that as investors passively pour money “into” the stock market and if existing holders are reluctant to sell, prices can advance and retain that advance permanently. The argument seems to trace to an NBER working paper a few years ago, containing assertions like “the price impact is perfectly long-lasting. This is not necessarily because flows release information, but instead simply because the permanent shift in the demand for stocks must create a permanent shift in their equilibrium price.”

“The problem is that such an assertion implies that “flows” effectively divorce price movements from their underlying cash flows, and investors permanently accumulate stocks regardless of the long-term returns implied by their cash flows. This is our very definition of a bubble.”

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Wishing you good health, success and good luck. Till next time……

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever-changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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