Last week was an ugly week for the equities markets where we witnessed the SPX Index (NYSEARCA:SPY) losing 6.7% on the backdrop of a fourth rate hike from the Fed and fears of a government shutdown over the U.S.-Mexico border funding. This article aims to discuss what government shutdowns could mean for markets and a historical price action study on various asset classes was conducted for the past three government shutdowns.
Every Government Shutdown is Different
A government shutdown occurs when the Congress does not pass funding bills or the president fails to sign them before the previous appropriations run out. That being said, every government shutdown is different in term of the duration of government shutdowns in days and the reasons for the shutdown. Since 1981, funding gaps have caused the government shutdown on 12 occasions as shown in Figure 1.
Every shutdown is different; for instance, the shutdown that occurred in January 2018 was primarily due to the Deferred Action for Childhood Arrivals (DACA) policy and it lasted almost three days. The shutdown in February 2018 was due to objections regarding the bipartisan two-year spending bill and it lasted for a day. However, the most recent government shutdown revolves around funding issues pertaining to the U.S.-Mexico border. The bottom line is the reason for each government shutdown is different and the duration of government shutdown varies as well.
Some may argue that since about 75% of discretionary federal spending for this year has been approved, the negative impact on markets should be limited; from the article, S&P Global Ratings estimated the costs of a shutdown now would be more modest if not muted relative to the size of the economy. However, this time could be different considering Mr. Trump threatened that a shutdown will last for a very long time if he does not get the money for his U.S. border wall. Furthermore, another headwind would be the disagreements not just between Democrats and Republicans but between some of the Senate members within the Republican party who are not on the same page as Mr. Trump. Moreover, once the 116th Congress convenes on January 3 next year, Democrat will take control of the house and disagreements between Congress and the White House will continue. Hence, the fiscal policy uncertainty will continue to lead to a more risk-off environment as we march into a new year which may not bode well for equities.
Historic Price Action Study of Government Shutdown on various Asset Classes
A historic price action study of the past 3 government shutdowns was conducted to see the price action pertaining to different asset classes. There are two columns for each asset class as shown in Figure 2. The column on the left ("During") shows the price change during the government shutdown. The column located on the right ("1M After") shows the price change 1 Month after the end date of the government shutdown.
During the Government Shutdown
It is interesting to see how each asset class reacts during past government shutdowns. Fiscal policy uncertainty is normally associated with a risk-off reaction in the financial markets. We naturally would expect safe-haven assets such as U.S. Treasuries and gold to perform. However, this is not the case as it is only two out of three occasions where U.S. 10-year yields have fallen, decreasing one basis point on average. This is also reflected in gold where it declines two out of three occasions and it has fallen 0.2% on average. Interestingly, the winner is the SPX Index, which actually edged higher for the past three occasions of a government shutdown and increased 1.6% on average. Hence, it appears that safe-haven assets may not actually perform but instead risky assets (like the SPX Index) will perform during the government shutdown if history is to repeat itself.
1M After the Government Shutdown
After we have examined the notable price action during the government shutdown, we examined how price action performed one month after the government shutdown end date. The clear observation would be for U.S. Treasury yields to climb higher (historically, 14 basis point have been added on average). Another notable trend would be for USD/JPY to climb higher since it has increased 1.2% on average two out of three occasions.
To conclude, while it is true that the government shutdown warrants our attention, the fact of the matter is every government shutdown is different. The impact on the markets will ultimately depend on the duration of the shutdown and how relevant stakeholders go about resolving the matter. That said, investors should also take into consideration other major headwinds such as slowing global growth and U.S.-China trade wars as we march into a new year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.