Do government shutdowns matter to markets?

A legislative deadlock stemming from disagreements over health care subsidies and executive power has led to the first U.S. government shutdown in nearly seven years. With a sharply divided Congress failing to agree on either a 2026 federal budget or a continuing resolution to keep funding the government, a full shutdown took effect at 12:01 am Oct. 1, and will likely continue until the two sides can reach a resolution.

For Democrats, a major contention point is the expiration of tax credits for Affordable Care Act marketplace health insurance, which could reduce enrollment by 4 million and increase premiums in 2026. Democrats see the ongoing talks as a chance to negotiate political concessions, while GOP lawmakers view their separate proposal to repeal Medicaid cuts as a non-starter.

Will the legislative impasse rattle the economy and markets? Here’s what investors are asking.

A: The government shutdown may cause only modest losses in gross domestic product (GDP), with a lengthy shutdown potentially having a greater effect on growth. Morgan Stanley economists estimate that real quarterly GDP growth is reduced by 0.05 percentage points directly for every week of a shutdown, based on historical precedent.

During the last shutdown, in 2018-2019, approximately 660,000 federal workers went without pay for over a month. However, GDP fell just $3 billion, according to the Congressional Budget Office—indicating that GDP that year was just 0.02 percentage points smaller than it would have been otherwise.

While investors may worry about financial and economic uncertainty, it’s key to note that government shutdowns are 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.

That said, the current administration has indicated that it could use the shutdown as an opportunity to reduce the federal workforce and cut programs that do not align with the president’s agenda, which could have greater economic consequences.

A: A shutdown could cause some temporary instability in bond prices, although such turbulence isn’t a given. The MOVE Index, which measures bond market volatility, rose 3.6% during the shutdown in 1990 and 7.2% in the 1995-1996 shutdown. However, the volatility gauge fell 12.6% and 14.8% during the shutdowns in 2013 and 2018-2019, respectively.

Given today’s high yields, Morgan Stanley’s Global Investment Office thinks U.S. Treasuries remain attractive and would encourage investors sensitive to the risks of a shutdown to opt for increased Treasury exposure. On average, during shutdowns since 1976, the 10-year Treasury yield has fallen 2.2 basis points while its price has ticked up, suggesting that investors favor the safe-haven asset during these periods of uncertainty. What’s more, the government can still pay bondholders during shutdowns, so coupon payments would not be at risk.

A: Historically, government shutdowns have had minimal negative impact on the U.S. stock market. The S&P 500 Index has gained an average of 4.4% during such events and remained in positive territory during the last five shutdowns. This suggests that broader economic factors play a greater role in market performance than legislative deadlocks.

Investors may want to look for opportunities in the defense and healthcare sectors, which are highly dependent on government contracts. 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. 

These sectors’ performance has varied during past shutdowns. For example, during the 2018-2019 partial government shutdown the defense sector outperformed the S&P 500 while the healthcare sector lagged—but in the 2013 full shutdown, healthcare outperformed while defense lagged due to paused contracts and payments. The full shutdown this time may affect defense to a greater extent, but could provide attractive entry points for investors looking to add exposure to the sector. In the long run, we believe defense may benefit from fiscal support, government prioritization, AI adoption and mounting geopolitical tensions.

When considering which of these investments may fit into your portfolio, be sure to keep in mind individual goals, timelines, and risk tolerance. Past performance is not guarantee of future results.

Find out more in Morgan Stanley Wealth Management’s report “US Policy Pulse: Do Government Shutdowns Matter to Markets?” Connect with a Morgan Stanley Financial Advisor to request a copy and discuss how you may want to position your portfolio.

Article Footnotes

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

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