U.S. Stocks at Risk With Government Shutdown Looming

Even as the U.S. stock market roars to new highs, helped last week by the Federal Reserve, a risk is rising from another corner of Washington.

Hardening positions on the federal budget and borrowing limit, and recent political setbacks suffered by both President Barack Obama and Republican congressional leaders as they go into the fight, are raising the odds of a government shutdown, debt default or near-miss that could roil equities markets.

“We are in for another ugly confrontation,” said Howard Ward, the chief investment officer for growth equity at Rye, New York-based Gamco Investors Inc., which oversees about $40 billion. “Even though everyone knows the impasse will be short-lived, it is a sad reminder of how dysfunctional Washington has become. It will be a catalyst for taking profits after the recent run-up.”

Forty percent of global investors surveyed in a Sept. 10 Bloomberg poll said they would pull back on U.S. markets in the event of a government shutdown, which many economists say would be less damaging than a debt default.

“This is a sleeper issue right now, but it could really come to the fore,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York. “There is a risk of the stock market selling off a thousand points over two or three days.”

A protracted standoff on budget issues, even if a default or government shutdown is averted, could cut economic growth by a full percentage point in the fourth quarter, Rupkey forecasts.

‘Additional Risks’

Federal Reserve Chairman Ben S. Bernanke cited the danger to the economy from the budget battles as one reason the central bank decided not to pull back on its monetary stimulus.

“Upcoming fiscal debates may involve additional risks to financial markets and to the broader economy,” Bernanke said at a Sept. 18 news conference on the Fed action.

So far, financial markets haven’t been shaken by the prospects of an impasse, with the Standard & Poor’s 500 stock index up 20 percent this year as of Sept 20, putting U.S. stocks on pace for the best annual gain in four years.

Credit default swaps tied to U.S. Treasury notes, which typically go up as investors’ perceptions of creditworthiness deteriorate, traded Friday at about 23 basis points, or 0.23 percentage point, according to data provider CMA. That compares with the average price of 41 basis points over the past three years.

Next Thing

“Investors are just toggling over from the Fed meeting to the debt ceiling,” said Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees about $364 billion. “The cliché is that the market can only focus on one thing at a time and next month this is going to be the thing.”

The last time Obama and Congress were at a stalemate over the debt ceiling, in 2011, Standard & Poor’s lowered the government credit rating. Bond investors weren’t dismayed and yields went down while equity markets were briefly rattled.

The S&P 500 stock index fell 16.8 percent between July 22, 2011, when talks on a broad deal faltered, and Aug. 8, the first trading day after the government’s AAA debt was downgraded. Every stock in the S&P 500 Index fell on Aug. 8. The index rebounded to close with a gain of about 12 percent for the year.

Now, Obama is stepping up his rhetoric in urging Congress to pass legislation to avert a debt default or government shutdown, warning in a Sept. 20 speech that Republicans risk creating “profoundly destructive” consequences for the U.S.

Undermining Confidence

With the economy in the second quarter of this year growing at a tepid 2.5 percent annual pace and slowing to 2 percent in the third quarter, according to the median forecast of economists surveyed by Bloomberg News, a lengthy debate over the budget could undermine the confidence of businesses, investors and consumers, Rupkey said.

“What I’m really afraid of is the economy going on pause as we wait for these clouds of uncertainty to lift,” he said. “It’s turning on the TV every night and hearing the angry exchanges on both sides that creates the uncertainty.”

Not all analysts think a lengthy stalemate would inflict as much damage.

Chris Hyzy, who helps oversee about $325 billion as chief investment officer of U.S. Trust, said he expects “ripples or speed bumps, not significant giant potholes” in the markets, anticipating a “3 to 4 percent, maximum 5 percent” pullback in the S&P 500 under a protracted budget battle.

Temporary Setback

“Any market drawdown would be temporary in nature. Sentiment is still skittish across the board,” Hyzy said. “We’ve seen the Polaroid photo before; we’ve gotten ourselves through it in a much more difficult time than we are today, and we are further and further away from the credit crisis with much healthier balance sheets.”

With House Republicans now demanding the permanent defunding of Obama’s signature health-care law as the price for even a temporary measure to keep the government open through Dec. 15, Chris Krueger, a Washington analyst for Guggenheim Securities LLC, put the odds of a government shutdown in the next two weeks at four in 10. Funding to operate the government runs out with the Sept. 30 end of the federal fiscal year.

A government shutdown in early October driven by partisan intransigence would hit financial markets mindful of another potential crisis just weeks away: The U.S. government will exhaust its borrowing authority and go into default by mid- to late October unless Congress and Obama can agree to raise the legal debt limit.

“As serious as a government shutdown would be, it is nothing compared to what could happen if Washington fails to raise the debt ceiling,” Krueger said.

Party Revolt

Obama enters the fight diminished by revolts within his own Democratic Party over his threats of military action in Syria and potential nomination of Lawrence Summers to head the Federal Reserve. His job approval, at 45 percent in the Gallup Poll for Sept. 9-15, is in the same territory as George W. Bush in the comparable period of his presidency, immediately after Hurricane Katrina devastated New Orleans.

Congressional Republicans, held in even lower esteem by the public, are riven by ideological conflicts. Earlier this month, House Speaker John Boehner of Ohio had to pull his plan for a stopgap funding measure from consideration as rank-and-file Republicans deserted him. Last week, he won backing from party members for a temporary funding bill that would eliminate the health-care law -- a condition the White House has said it would never accept.

Weak Position

“Both sides, the president and the House Republicans, are dealing from a position of weakness, and that makes it hard,” said former House Speaker Dennis Hastert, an Illinois Republican.

Obama says he won’t make concessions to Republicans to raise the borrowing limit.

Republicans are “not focused on you, they’re focused on politics, they’re focused on trying to mess with me,” he said on Sept. 20 at a Ford Motor Co. plant near Kansas City, Missouri, hours after the House voted to finance the government through Dec. 15 and choke off funding for the health-care law. A “faction on the far right of the Republican Party” is willing to put the U.S. economy at risk, he said.

Senate Republican leader Mitch McConnell of Kentucky, who has helped broker compromises with the White House, is consumed with a tough primary challenge and is trying to avoid the role of dealmaker, said Stan Collender, a onetime Democratic congressional budget aide.

Recalling Clinton

Neither Obama nor Boehner bring the same political strength to the negotiating table as former President Bill Clinton and House Speaker Newt Gingrich, who agreed to balance the federal budget in 1997 after a struggle that included two government shutdowns, said Collender, a partner at Qorvis Communications.

Clinton was both more popular during the comparable period of his presidency and had more skill at persuading the public of his views, Collender said. Obama’s 45 percent job approval in the Gallup Poll compares with 58 percent for Clinton on Sept. 25-28, 1997.

Boehner doesn’t have the same loyalty from House Republicans as did Gingrich. Gingrich “had the ability to go back and sell the deal to his conference,” said Hastert. “Sometimes there were people who would straggle, but by and large they would buy in.”

Congress’s job-approval rating is near an all-time low, at 19 percent in a Gallup Poll taken Sept 5-8.

“You would think that would prompt a serious introspection and motivate them to take bipartisan action to do what is right for the country,” said former Senator Olympia Snowe, a Maine Republican who often tried to forge bipartisan coalitions.

Fearing Challenge

Snowe said her former colleagues worry more about the possibility of a challenge from a more ideological opponent in a party primary.

While the bond market wasn’t fazed during the 2011 conflict over raising the U.S. debt limit, stock investors turned pessimistic when efforts collapsed to reach a broad deal to address long-term fiscal challenges.

Yields on 10-year Treasury notes declined to 2.61 percent on Aug. 2 of that year, from 3.18 percent on July 1, 2011, and continued to fall to 1.88 percent at year-end.

Research published earlier this year by the New York Federal Reserve Bank concluded that the standoff might have had a bigger impact on credit markets had it not been for a flood of funds out of Europe driven by the continent’s debt crisis.

“The relatively benign effects of the 2011 U.S. debt-ceiling crisis on U.S. financial markets appear to have been serendipitous, as the U.S. and European debt crises occurred concurrently,” the authors concluded. “Money funds nevertheless reacted to the increased riskiness of Treasuries by dramatically decreasing the maturities of Treasuries held in their portfolios during the debt-ceiling crisis. This behavior suggests that we can’t be sure that the effects of future fiscal crises on financial markets will be similarly benign.”

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