The Fight Begins

The week has no short of market changer events. Investors do have plenty on their plate, from the Evergrande debt saga to the Fed decision and the impending government shutdown risk.

A Government Shutdown & Equity Market

Given a deadlock among lawmakers in addressing the suspension of the debt limit, it is clear that The US Treasury will run out of options to continue financing US debt obligations. More recently, the White House had given the order for federal agencies to prepare for a potential shutdown that is likely coming next week if Congress cannot reach a consensus on government funding.

The market has been relatively muted given that the S&P 500 and Dow Jones Industrial Average closed the week with a modest gain. Unless we see Congress moves in to approve the funding bill by 30 September,  we will usher in the first government shutdown in a pandemic era, which is also the fifth time over a decade. This reflects how widely misaligned political parties are in the recent economic politics debate.

House Democrats Speeding up the Engine

On Wednesday, we read how the House Democrats had approved a bill that provided the government with funding till 3 December and suspended the debt limit. It is a crucial move. Without the move to suspend the borrowing limit, the US will enter a default situation on its loan, which Auntie Yellen had gravely warned Congress.

Yet, this fell on deaf ears for the Republicans as the bill is expected to be dead on arrival when it reaches the Senate since it will require at least 10 Republicans to join the ranks of Democrats to approve the bill.

Impacts on Equity Market

Historically, Pika World does not see a government shutdown permanently affecting the broader market. Since 1980, we had seen around 14 shutdowns where the S&P 500 registered a median return of around -0.1% on the day when the budget expires and 0.1% when the shutdown is happening, and a growth of 0.3% when the shutdown ended.

Based on the Dow Jones Market Data analysis, one can observe that for the past 4 shutdowns that spread for more than 5 days, the S&P 500 had made gains. For example, the most recent shutdown on 25 January 2019 lasted for about 35 days, yet the S&P 500 rose by around 10%.

This shows how the market tends to rebound sharply after the dark clouds disperse. On average, we can observe a positive month after a government shutdown occurs. Although the impact to the equity market tends not to be adverse in the long run, it has a profound implication on the macro environment, as some analysts believed.

The continuous debate over the US debt limit and whether the Treasury can pay its bill is undoubtedly a growing risk for the market. Yet perhaps this risk has been side-tracked by market participants in anticipation of a large stimulus bill that the Democrats are looking to pass after resolving the debt ceiling fight.

Bipartisan has been the Way

Pika World does not believe the suspension of the debt ceiling needs to be partisan. Both Democrats and Republicans have always worked together to raise the debt limit to avoid potential defaults in the past. During the Trump era, Democrats and Republicans had joined forces to suspend the debt limit for three accounts.

Understanding the Debt Limit

It might be helpful to understand that when the debt limit is suspended or increase, it does not empower the current administration to make new spending. Instead, it is simply a power given to the federal government to meet its obligation of payment on bills due to previous budgetary decisions.

Essentially, the debts to be incurred by the US are derived from the legislation passed by past Congresses and administrations. Examples are the 2020 Cares Act to help alleviate the harsh impacts of the pandemic, the 2017 Tax cuts by the Republican administration, and bills enacted by the Democratic administration, including the extension of tax cuts by George W. Bush.

It will be Socially Painful

During a shutdown, the federal government tend to impose stringent and extensive spending cuts of around $1.2 trillion, beginning on 1 October. The amount will affect 30% of the federal program’s funding except Social Security, Medicare Hospital Insurance and the interest on the debt incurred. Spending cuts, in general, tend to amount to around 5% of GDP, which could throw the economy into a self-inflicted recession.

Robust fiscal spending has underpinned the US economy recovery story in reviving an ailing economy that uplifts Americans’ hardships. However, any cuts mean households, including businesses, may default on their bills as they wait for federal payments to reach their account. This has broad ramifications to the consumers’ confidence to spend and businesses willingness to invest in a period of political deadlock.

Despite many downside risks, Pika World believes that the political-economic situation, while sour, may reach a sweet conclusion as the ester perfumes the market and the music continues for the equity market movement.

Your friend,

Pika Nat