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What Does the Government Shutdown Mean for Investors?

Not much on its own, but it's a canary in the coal mine.

The partial shutdown of the federal government has stretched into its second week, and right now there are few signs of compromise. At the same time, major financial market indexes have bounced up and (mostly) down, partly because of the shutdown, among other factors. What lessons should investors take from the shutdown, and how might it affect their investing strategy?

Shutdowns should not directly affect most investors or their investments, although these appropriations lapses ultimately cost the government money, and economists agree that they slightly reduce gross domestic product growth, particularly during longer shutdowns. Still, shutdowns provide an important piece of information: They are indicators of the extent of the gridlock between lawmakers. 

That gridlock, in turn, impedes the government from doing all kinds of routine business to keep the economy running smoothly, which has already recently led to a few annoyances for businesses and investors. A dysfunctional Congress or a clash between Congress and the president could potentially lead to much bigger problems in the next few months. 

Shutdowns have been regular features of American government ever since Congress set up the modern appropriations process in 1974. The first major appropriations lapse occurred in 1981, to be followed by shutdowns in 1984, 1986, and 1990. We got a break between 1996 and 2013, but 2018 featured two shutdowns. You probably do not remember them, and that's because most people don't unless they wanted to visit a shuttered park or needed to call the IRS for guidance. (Of course, hundreds of thousands of federal employees are currently furloughed or working without paychecks, but these workers were always paid back in previous shutdowns. Contractors working for federal agencies may not be so lucky.)

However, the shutdown illustrates how difficult it will be for Washington to get anything done in the period of divided government that commences Jan. 3, 2019, when Democrats take the majority in the House. (To be fair, the last Congress was generally unproductive as well, during a period of unified government.) The shutdown is a lagging indicator for recent failures to pass legislation with bipartisan support, including bills that would have made technical corrections to the tax code, improved small employers' options for offering retirement plans to their workers, and enhanced lifetime income options for retirees, among other policy issues that we cover at Morningstar.

More concerning, the shutdown is a leading indicator that Congress and the president just might fail to take care of the biggest piece of routing business there is: raising the debt ceiling. To cut to the chase, sometime this summer, Congress will need to raise the debt ceiling so that the Treasury can borrow enough to pay the bills that Congress has already incurred. The debt ceiling is often conflated with a shutdown, but it is a completely different animal, and a much scarier one. 

For arcane historical reasons, we separate the laws on the amount of money the government can borrow from its obligations to spend money above the amount of revenue we collect in taxes. In short, the debt-ceiling fight is about whether the laws about how much to spend will clash with laws about how much to borrow, and if they do, the U.S. government will default on some of its obligations--an outcome that will shake financial markets to their core given that the markets consider U.S. Treasury bills, notes, and bonds to be riskless.

The most likely case is that Congress will raise the debt ceiling as it always has. In fact, the incoming house majority plans to adopt a rule to automatically raise the debt ceiling when they pass a budget, which should help mitigate some of these issues. Still, the last major debt-ceiling crisis in 2011 illustrated that Congress could extract policy concessions by playing chicken with the economy. That's a potentially dangerous precedent in a period of increasing gridlock and animosity. The current debt ceiling lapses on March 2, after which the government uses "extraordinary measures" to keep from defaulting on its debts. Investors should expect more volatility as markets try to price in the risks of the U.S. government failing to pay its bills and some continued drag on the economy to the extent it cannot perform other routine but important housekeeping.