Would a government shutdown matter to markets?

Key takeaways:

• A potential US government shutdown may cause only modest losses in economic output, based on historical analysis.
• Fixed-income volatility could increase, but given today’s high yields, Morgan Stanley’s Global Investment Office (GIO) believes US government bonds remain attractive.
• Some investors are considering opportunities in the defense and healthcare sectors, which could rally during a shutdown.

It looks increasingly likely that the US government is headed for a shutdown on Oct. 1. To avert this outcome, Congress would have to pass 12 separate bills to fund federal agencies by the end of the fiscal year on Sept. 30. However, lawmakers remain at odds over a host of issues, including proposals for new reductions in spending, the restoration of expired cuts to corporate taxes, and an expansion of the child tax credit.

The Biden Administration has asked Congress to pass a “continuing resolution” that would temporarily keep government operations running at the same level as the previous fiscal year. However, if a shutdown ultimately comes to pass, it could mean furloughs for federal employees and disruptions to food or childcare assistance programs.

Coming on the heels of a closely watched debt-ceiling standoff, will continued government brinkmanship rattle the economy and markets?

Here’s what investors are asking:

A: A government shutdown may cause only modest losses in gross domestic product (GDP). During the last shutdown, in 2018-2019, an estimated 800,000 federal workers went without pay for over a month. However, GDP fell just $3 billion (equivalent to 0.014% of 2018 GDP) the following quarter, according to the Congressional Budget Office. Looking back, the 20 government shutdowns that have occurred since 1976 appear to have had limited impact on the economy, with inflation-adjusted, or “real” GDP still growing an average 2.2% during shutdowns.¹

While investors may worry about financial and economic uncertainty, it’s key to note that government shutdowns are usually temporary– on average, they have lasted just over a week. Furthermore, government agencies and staff are made whole for the missed revenue as soon as a federal budget is approved. This relatively short timeline, along with eventual back pay, weakens broader economic impacts.

A: A shutdown could cause some temporary instability in bond prices, although such turbulence isn’t a given.

Given today’s high yields, Morgan Stanley’s GIO believes US Treasuries remain attractive. GIO also believes that  investors that are sensitive to the risks of a shutdown may opt for increased Treasury exposure as these investors may favor this particular asset during periods of uncertainty. What’s more, the government can still pay bondholders during shutdowns, so coupon payments would not be at risk.

A: Although past performance is not indicative of future results, government shutdowns have historically had minimal negative impact on the US stock market, with the S&P 500 Index gaining an average 4.4% during such events.

GIO notes that the defense and healthcare sectors are highly dependent on government contracts. With those sectors currently underperforming the S&P 500, the prospect of a shutdown may present an attractive buying opportunity today.

During shutdowns since 1995, the defense sector gained 5.2% and the traditionally defensive healthcare sector advanced 2.3%, compared with the S&P 500’s 3% return. Beyond the risk of a shutdown, other factors also contribute to this view: In the longer term, government spending and incentives could boost both sectors. For example, ongoing geopolitical tensions are likely to spur additional government-funded investments in defense and cybersecurity, while pharmaceutical and healthcare providers appear poised to benefit from the Affordable Care Act’s expansion and federal support of Medicare.

The source of this article, Would a Government Shutdown Matter to Markets, was originally published on September 13, 2023.

¹ The change in GDP from the quarter prior to the shutdown to the quarter when the shutdown occurred.