Possible Consequences of the Government Shutdown & Default

It’s possible that you’ve heard a news report or two about the government shutdown  that started October 1, and now a dispute over raising the U.S. debt ceiling and possibly defaulting on the government’s debt obligations as soon asOctober 17.  The question for an increasingly nervous investing public is: how will this affect the U.S. economy and (not to be too selfish here) my retirement portfolio?
Interestingly, it is starting to look like the government shutdown, if it runs for weeks instead of months, might have almost no effect on the economy at all.  Why?  The economic impact that had economists worried was the loss of income suffered by tens of thousands of federal employees.  But the Defense Department has continued paying all of its civilian personnel, simply by declaring all of them “essential employees.”  Not only were the leaders of the House of Representatives not inclined to argue; they have quietly passed legislation that would give back-pay to all federal workers who have been furloughed, just as soon as the stalemate ends.  The Senate and the President are likely to go along, giving the country the worst of all worlds: paying most government employees for staying home and not providing a wide variety of services to the public.
Ironically, the way the politics are working, one can almost guarantee that there will continue to be a stock market selloff before the shutdown ends.  For the Republican leaders in the House, there is little cost to holding their ground so long as there is not a public outcry and loss of voter confidence.  One of the sources of that pain would be a big drop on Wall Street.  Indeed, if you listen closely to the speeches by President Obama and the Democratic leadership, you hear dire warnings of a market drop as a result of the shutdown–which is their way of focusing the public’s attention on who to blame as it happens. 
What is interesting about that is that the markets often deliver corrections after long, accelerating uptrends like what we have experienced in the U.S. since March of 2009, and with the 20+% returns that Wall Street has delivered so far this year.  It wouldn’t have surprised anyone to see some kind of a quick downturn this Fall regardless of whether the government was operating at full capacity or at a standstill.  A week of small leaks in stock prices could lead to something larger as people realize they are sitting on nice gains and have no idea what Congress will or won’t do next.  The last time the government was shut down, stocks dropped almost 20%, the Republican leadership realized it wasn’t winning any popularity contests and the stalemate ended.  We’ve seen this script before.
A more consequential issue is the debt ceiling.  Congress must raise the total amount that the U.S. government can borrow (by selling Treasury bonds) to pay its various obligations, including, of course, interest on its current Treasury bonds.  Contrary to popular belief, raising the debt ceiling does not increase the federal debt; that debt exists whether or not Congress authorizes additional borrowing.
Failure to authorize the government to pay its legal obligations would create a self-induced fiscal crisis–ironic for a country whose representatives claim that they never want to become another Greece, and then talk about voluntarily defaulting on the nation’s debt obligations, which even Greece has avoided. 
One recent article suggested that a default on Treasuries would ripple through the global economy, among other things, causing anxious investors to demand higher interest rates and dramatically raise U.S. borrowing costs.  That, in turn, would raise rates on mortgages, credit cards and student loans, pushing the U.S. toward or into recession, and putting pressure on the stock market.  One report suggests that if the U.S. misses just one interest payment, the downward impact on stock prices would be greater than the Lehman Brothers bankruptcy.  In THAT aftermath, the stock market lost more than half its value.
Bigger picture, a default would undermine the role of the U.S. in the world economy.
As I previously wrote, the irony of the debt ceiling debate is that the gap between government spending and tax revenues has been closing rapidly on its own.  In July, the Congressional Budget Office reported that the deficit had fallen by 37.6%, the result of tax increases and sequester-related cuts in spending.  As a percentage of America’s GDP, the deficit has fallen from more than 10% at the end of 2009 to somewhere around of 4% currently.  Last June, the government actually posted a surplus of $117 billion, paying down the overall deficit, and the Congressional Budget Office has projected that September will also bring government surpluses.
Most observers seem to think that all of this will get worked out.  After all, what rational person–in Congress or elsewhere–wants to self-impose these problems when we have plenty of economic challenges already?  The stock market’s relatively calm trading days tell us that investors expect a compromise on the government shutdown in the near future.  Nonetheless, it may take a sharp day of selling to prod Congress off the dime.  Foreign investors are still lending to the U.S. government at astonishingly low interest rates (despite modest increases over the past week), which tells us they aren’t worried about a default.
The previous times we went through events similar to this, the stock market plunges proved to be buying opportunities for investors.  One of the great things about uncertainty and volatility is that it causes investments to periodically go on sale, and creates such anxiety that only disciplined (and perhaps brave) investors are able to take advantage.  There’s no reason to think this won’t be more of the same.




My thanks to Bob Veres of Inside Information for his help with this post

Scary Headlines, Remarkable Returns-3rd 2013 Quarterly Financial Review

The threat of a government shutdown virtually guaranteed that the investment markets would close out the third quarter with a whimper rather than a bang.  The S&P 500 index lost 1.1% of its value in the final week of the quarter as the U.S. Congress seemed to be lurching toward a political standstill that would shut down the U.S. government.  All the uncertainty has tended to obscure the fact that most U.S. stock market investors have experienced significant gains so far this year.
And the recent quarter was no exception.  Despite the rocky final week, the Wilshire 5000–the broadest measure of U.S. stocks and bonds–rose 6.60% for the third quarter–and now stands at a 22.31% gain for the first nine months of the year.  The comparable Russell 3000 index gained 6.35% in the most recent three months, posting a 21.30% gain as we head into the final stretch of 2013.
Other U.S. market sectors experienced comparable gains.  Large cap stocks, represented by the Wilshire U.S. Large Cap index, gained 6.24% in the second quarter, and are up 20.77% so far for the year.  The Russell 1000 large-cap index returned 6.02% for the quarter, up 20.76% for the year, while the widely-quoted S&P 500 index of large company stocks gained 5.32% for the quarter and is up 18.62% since January 1.
The Wilshire U.S. Mid-Cap index index rose 9.02% in the latest three months of the year, and is up 26.19% as we enter the final quarter.  The Russell midcap index was up 7.70% for the third quarter, and now stands at a 24.34% gain so far this year.
Small company stocks, as measured by the Wilshire U.S. Small-Cap, gained 9.68% in the third quarter; the index is up 27.53% so far this year.  The comparable Russell 2000 small-cap index was up 10.21% in the second three months of the year, posting a 27.69% gain in the year’s first nine months.  The technology-heavy Nasdaq Composite Index was up 11.16% for the quarter, and has gained 25.24% for its investors so far this year.

Keep in mind that while a diversified portfolio of cash, stocks, bonds, real estate and other asset classes may not provide you with the full returns shown above, you are also not taking on the risk of a 100% equity portfolio. That’s just smart money and risk management.
In the first half of the year, any diversification into investments other than U.S. stocks were dragging down returns.  That was no longer the case in the 3rd quarter.  The broad-based EAFE index of larger foreign companies in developed economies rose 10.94% in dollar terms during the third quarter of the year, and is up 13.36% so far this year.  The biggest surprise is Europe: a basket of European stocks rose 13.16% over the past three months, which accounts for virtually all of their returns this year; the index is now up 13.17% for the year. 
Emerging markets stocks are climbing out of a deep hole that they fell into earlier in the year, returning 5.01% in the past three months, even though the EAFE Emerging Markets index is still down 6.42% for the year. 
Other investment categories are not faring so well.  Real estate, as measured by the Wilshire REIT index, fell 1.98% for the quarter, though it is still standing at a 3.84% gain for the year.  Commodities, as measured by the S&P GSCI index, reversed their recent slide and rose 5.44% this past quarter, taking them to nearly even, just down 0.27% so far in 2013.  Gold prices perked up on the uncertainty over the government shutdown, gaining 9.26% in the recent quarter, though gold investors have lost 20.48% on their holdings so far this year. 
Bonds have continued to provide disappointing returns both in terms of yield and total return.  The Barclay’s Global Aggregate bond index is down 2.24% so far this year, and the U.S. Aggregate index has lost 1.87% of its value in the same time period. 
In the Treasury markets, the year has seen a bifurcated market; declining yields in bonds with 12 month or lower maturities, while longer-term bonds have experienced rising yields and a corresponding decline in the value of the bonds held by investors.  In the past year, the yield on 10-year Treasuries have risen almost a percentage point, to 2.65%, and 30-year bonds are now yielding 3.73%, up 86 basis points over the past 12 months.    
Municipal bonds have seen comparable rate rises; a basket of state and local bonds with 30-year maturities are now yielding 4.32% a year; 10-year munis are returning an average of 2.56% a year.  The rises, of course, have caused losses in muni portfolios.
Perhaps the most interesting thing to notice about America’s 20+% stock market returns so far this year–extraordinary by any measure–is that they were accomplished at a time when investors seemed to be constantly skittish.  Just a few weeks ago, everybody seemed to be worried that the Federal Reserve would end its QE3 program and let interest rates find their natural balance in the economy.  One might wonder why this would be such a scary event, since it is the Fed’s economists way of telling us that the U.S. economy is finally getting back on its feet.
All eyes are still on Washington, but now they’ve moved from the Fed to the Capitol Building.  The question everybody has been asking in the final days of the quarter is: what would be the investment and economic impact of a government shutdown?  This question might be one to consider going forward, since the two parties seem to have a lot of fundamental disagreements over spending priorities, and budget battles could become quarterly events.
An article in the Los Angeles Times says that most economists and analysts seem to expect a partial two-week government shutdown.  The lost pay for hundreds of thousands of furloughed federal workers would cut 0.3 to 0.4 percentage points off of fourth quarter growth–the difference between weak 2% growth annual growth that the economy is currently experiencing and an anemic 1.6% growth rate that would be flirting with recession.  An estimate by Goldman Sachs puts the potential lost GDP at 0.9%.
A longer shutdown could cause disruptions in private-sector production and investments, and would almost certainly lead to stock market declines.  The L.A. Times article notes that stocks lost about 4% of their value during the December 1995-January 1996 shutdown.  Job growth stalled, and the GDP gained just 2.7% in that first quarter. Interestingly, in all cases of past government shutdowns, the stock market recovered all of the losses and then some. That could be why the market is holding up well right now, but a protracted shutdown creates uncertainty and the markets hate uncertainty.
Interestingly, Congress has quietly moved away from the issue that has triggered the last few budget stalemates, focusing this time on whether or not to fully fund President Obama’s health care legislation.  In the past, the issue was budget deficits, but it turns out that the budget deficit has come down dramatically over the past 12 months.  The U.S. government posted a $117 billion surplus in June, and the Congressional Budget Office expects to run a surplus again in September–the result of revenue gains as a result of tax hikes plus the growing economy, coupled with a 10% reduction in spending. 
What does all this mean for your investments in the final 2013 quarter?  Who knows?  Nobody could have predicted, at the start of the year, with all the hand-wringing over the fiscal cliff and new tax legislation, that we would be standing nine months into 2013 with significant investment gains in the U.S. markets and a resurgence in global investments led by, of all places, Europe.
This much we can predict: the recent uncertainties–the paralysis in Congress, worries about the direction of interest rates and whether the Fed is going to stop intervening in the markets–will give way to new worries, new uncertainties, which will make all of us feel in our guts like the world is going to hell in a handbasket. With that said, the bull market that started in March 2009 is getting long in the tooth and is overdue for a longer period of rest (10% or more correction, or even a bear market)
Nonetheless, the headlines obscure the fact that investment returns are created the hard way, by millions of people getting up in the morning and going to work and spending their day finding ways to improve American businesses, generate profits, create new products and new markets, day after day after day. 
Whatever ups and downs you experience–and you WILL experience them, perhaps in the next quarter or the next year–that underlying driver of business enterprises and stock value is constantly working on your behalf.  That will be true no matter what the headlines say, no matter how spooked you feel about whatever scary thing is going on in the world.  Nobody enjoys the investment ride the way children enjoy the thrills of a roller coaster, but both seem to ultimately deliver their riders to a semblance of safety in the end.

I hope you’re having a great week and I welcome your questions, feedback and comments. If you or someone you know is looking for a fee-only fiduciary advisor or money manager who puts your interests first, please don’t hesitate to get in touch with me.


Wilshire index data: http://www.wilshire.com/Indexes/calculator/
Russell index data: http://www.russell.com/indexes/data/daily_total_returns_us.asp
S&P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–
Nasdaq index data: http://quicktake.morningstar.com/Index/IndexCharts.aspx?Symbol=COMP
International indices:http://www.mscibarra.com/products/indices/international_equity_indices/performance.html
Commodities index data: http://us.spindices.com/index-family/commodities/sp-gsci
Treasury market rates: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/
Aggregate corporate bond rates: http://finance.yahoo.com/bonds/composite_bond_rates
Government shutdown impact:  http://www.latimes.com/business/la-fi-shutdown-economy-20131001,0,155302.story
Budget surpluses:  http://www.cnbc.com/id/100880536
My thanks to Bob Veres, publisher of Inside Information for his help with this article.