By Cheryl I. Smith, Ph.D., CFA
How concerned should investors be?
While the U.S. stock and bond markets have shown some anxiety over the past two weeks, the stock market damage has been limited to less than 3% from the all time high reached in mid-September. Bond markets have been similarly calm. We think investors are correctly reading the economic signs and deciding not to panic.
As of midnight, October 1, the U.S. Congress had not renewed the budgetary authority for the U.S. government, with the Republican-dominated House refusing to pass a continuing resolution because of the Tea Party-led objections to the Affordable Care Act. As a result, the Federal government put contingency plans into place which designated which Federal employees were considered to be essential workers and which were to be immediately furloughed, that is, sent home without pay. Those employees considered to be essential will be working with delayed paychecks, that is, they can expect to eventually be paid but it is not guaranteed. Essential services will continue, including the distribution of Social Security benefits, homeland security, much of the military and essential health care services.
Simply put, the shutdown will reduce economic growth, perhaps by as much as 1.5% points, bringing the GDP growth rate down to 1% from 2.5%.
However, over the past nine months, consumers and businesses have been showing increasing resilience and willingness to spend, so we do not think the reduction in growth will cause the economy to tip into recession. Consumer and business resilience has been substantial enough that the Federal Reserve signaled that it might start reducing quantitative easing in September. In reaction, bond yields were bid up sufficiently that the Federal Reserve did not need to reduce its purchases, or start “tapering”: bond yields had already gone up as much or more as the Fed would have wished to see with tapering. This underlying economic resilience forms the background against which the government shutdown is happening. While the shutdown will slow economic activity, it will not be enough to move the economy into recession.
We expect that the continuing resolution for budgetary authority and spending will soon be passed, and we do not expect that there will be further delays in the implementation of the Affordable Care Act. The prior shutdown in the government, 17 years ago, proved to be a political disaster for Republicans, and we expect the same result this time. The brunt of the immediate impact of the government shutdown will be felt by Federal Government employees, whether furloughed or deemed essential, as they will not receive paychecks until the continuing resolution is passed. Secondary effects will take some time to work through the economy.
We are more concerned about reaching the debt ceiling limit in mid-October, and view the current test of wills as a dress rehearsal for that debate.
About 25% of Federal spending, for the period that the government is shut down, will be permanently eliminated, such as paychecks for furloughed workers and “inessential” services such as safety inspections of food and agriculture. Another 25% of the spending will be delayed until the continuing resolution becomes law; this represents the delayed paychecks for those essential employees who will be continuing to work. Another 50% of Federal expenditures will continue, representing such areas as social security payments, the military, air traffic control, and homeland security.
We estimate that the permanently eliminated expenditure results in an approximately 0.5% hit to economic growth, or about 20% of the 2.5% growth rate experienced in the second quarter, bringing GDP growth down to 2% immediately. However, there are multiplier effects as well – employees who are not paid will reduce their spending, which reduces the income of others – think grocers, retailers, and child care providers. This multiplier effect is somewhere between 1.5 and 2 times, implying a reduction in the GDP growth rate of between 0.75% and 1%, bringing us to a GDP growth rate of 1.5% to 1.75%.
Overall, we do not expect that the government shutdown will be enough to push the economy into recession, but it will significantly lower near-term economic growth.