Thesis: Investors should ignore the coming budget crisis, and leave their asset allocations unchanged.*
The capital markets are now facing the risk that without a budget, the federal government will "shut down" on Tuesday, and that without an increase in the debt ceiling, the US will default on its debt later in the month. I am in no position to handicap either event, although the odds of shutdown are much greater than of a default.
My advice to investors is to ignore this entire operetta. Whatever economic impact it has will be brief and fleeting. A shutdown is pure theater, since it has very little economic impact. When the government shut down the last time (the winter of 1995-96), the economy kept growing, and the stock market did well. A shutdown is an economic nonevent.
The debt ceiling is a much more serious matter. If the ceiling is reached, and if the Treasury has no more expediencies (or chooses not to avail itself of more expediencies), and if the president allows a Treasury default, then there would be a temporary disruption in the credit market, causing a temporary decline in the bond and stock markets.
However, it should be emphasized that the Treasury/OMB can prioritize debt payments above other spending, and it can continue to roll maturing debt; it just can't issue new debt above the ceiling. The monthly deficit varies widely but is now averaging $100B, versus around $300B of spending. So about ¼ to ⅓ of monthly spending would need to be postponed or offset with asset sales or other maneuvers. That could be done if the Administration chose to pursue that avenue, although it has said that it won't.
It may be that both sides will be so dug in that neither will blink, and a default will occur. This is unlikely since Speaker Boehner has said that default is not an option, but his caucus may decide otherwise (or may depose him). A default would be a buying opportunity for both bonds and stocks because it would represent a screw-up, not a real economic problem. (Think of Y2K or 9/11.)
Insofar as a default causes a loss of market confidence that shows up in the capital markets or in the real economy, the Fed can offset the impact with words or actions. In extremis, the Fed can control the nominal economy. Once the default is cleared up, as it would be, bond and stock valuation will return to the fundamentals (which include the fact that the deficit is rapidly declining).
Note that, if the Treasury chooses to assign a low priority to the debt and does choose to default, it would only affect debt maturing during the period affected, not all federal debt. Certain securities would come due and be defaulted upon. Such securities will be "in default" in a technical sense, but are guaranteed a 100% recovery plus interest. The debt is neither excused nor extinguished. In the last ceiling scare, Moody's put only those affected maturities under review, and indicated that a downgrade would be modest and temporary, as expected loss remained zero. Should such securities decline in value, they would represent a minor buying opportunity.
Both rating agencies have said that the recurring default risk caused by the ceiling is a credit negative. This was one of the reasons for S&P's downgrade of the US from AAA to AA-. Moody's has maintained its Aaa, with a stable outlook, but isn't happy with the prospects of a default. They might react in some way to a default, but in respect of expected loss there is no reason to do so.
The creditworthiness of the US does not hang by a thread in John Boehner's fingers. The US is not Spain. The US, given the current trajectory of the deficit, remains a solid AAA in my opinion. I don't see how any corporate or structured security could be rated higher than the US. The country's debt burden is quite manageable, as evidenced by the extremely low yields on its obligations. CBO projects that federal debt to GDP will peak in a year or so, and then begin a steady decline for the rest of the decade: no fiscal crisis.
If a default occurs and is disruptive, the Fed will respond which might even spark a rally in stocks and bonds. The fundamentals will be unchanged.
The real challenge to the stock market today is the slowing economy, which may begin to appear in corporate earnings. Keep your eye on nominal growth. That's the real threat.
*I am not a registered investment advisor. Do not rely upon my opinions.