CIO Insights: The Push and Pull of Politics

Sep 21, 2017

In August, we wrote that markets may not be reflecting the risks associated with looming political fights over the debt ceiling, tax reform (or cuts), the unwinding of the Federal Reserve’s balance sheet, and the 2018 fiscal budget. Heightened geopolitical tensions globally, specifically those related to North Korea, have grabbed the market’s attention as well. The Dow Jones Industrial Average Index fell over 230 points in the first trading session after Labor Day weekend on reports that North Korea had tested a series of ballistic missile launches.

Now that we’re in September, historically a quieter month for the broader markets, we expect volatility to rise as lawmakers face deadlines on some major policy decisions. While there is now a 3-month deal to temporarily avoid a government shutdown or Treasury default until December, the road over the next few months could continue to be a bumpy one.

Some signs of a “risk-off” environment are already evident early in the month. For one, the yield on the 10-year Treasury hit its 2017 low, despite some positive economic data recently.

Source: US Department of Treasury. Data from 1/3/17 to 9/5/17.

With so much at stake in the coming weeks, investors may want to consider the following questions:

What Happens if a Budget does not get Passed?

Our research on this topic shows that in 2011 and 2013, market returns in the month leading up to reaching a new debt ceiling agreement (shown below) followed the broader direction of the respective market in those years, rather than completely reorienting the markets.

Failing to pass a budget would trigger a government shutdown, causing roughly 800,000 non-essential government jobs to be furloughed.1 Social Security and other essential services should not be affected. We believe a short-term shutdown of a few weeks or less would not be that big of a deal, in the grand scheme of things. But anything longer could potentially lead to a market selloff or even a recession.

The longest shutdown on record is the 27-day shutdown in 1995-96 between President Bill Clinton and the Republican Congress. The shutdown centered over funding for education, Medicare, and public health.

What Happens if the Debt Ceiling is Breached in December?

Anything that might jeopardize the U.S.’s credit worthiness could be a major shock to financial markets around the globe. If you recall, political games on Capitol Hill in August 2011 led the U.S. to the brink of default. As a result, credit rating agency S&P cut its rating on US debt from AAA to AA+ 2 causing significant concern among all types of investors who viewed US government debt as ‘risk-free’.3

Breaching the debt ceiling would be a political event with real impact.  In theory a breach, even for a relatively short amount of time could be significant because it likely would result in a downgrade of U.S. debt, meaning potentially higher borrowing costs and headwinds for the broader economy. While a downgrade of US debt has occurred, a breach has not.


Related funds

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Category: Commentary

Topics: Macroeconomic

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