How Markets May Deal with D.C. Dysfunction

Dysfunctional Washington has become a little more so. It looked, right up to the end, as though Congress, rather than shutdown the government, would fall back on the same kind of muddles it has used for the past three-plus years to delay the decision. But this time was different. Republicans demanded what Democrats could not give. Democrats refused to offer Republicans anything they might want. President Obama remained aloof. It was a failure of governance all around. The president characterized the mess well. It was, he said, the height of irresponsibility. But contrary to his intent, heavy blame attaches to all parties.

With past patterns broken, there is a wider field of possibility than previously thought. Still, likelihoods suggest that the shutdown will be relatively short-lived. It should, in fact, have a shorter duration than the 21 days the government stayed closed the last time this happened, late in 1995. After all, the political pressure on all parties, including the president, increases exponentially each additional day the shutdown continues. The impending need for debt ceiling legislation complicates matters. But if anything, it increases the political pressure for an accommodation and so the likelihood that Washington will find some way to end the impasse, even if only to make an interim solution along the lines of past muddles. Actually, the shutdown, by cutting spending, may buy a little extra time for Congress to act on the debt ceiling, but certainly not enough to relieve the political pressure.

If, as expected, the shutdown is relatively brief, it will have equally temporary effects on financial markets and the economy. In the past, such events, or the threat of them, have moved investors away from risk assets, such as lower-quality bonds and equities, toward deposits and high-grade bonds, including Treasuries, even though the problems originate with the government. The same pattern will likely take hold this time, too, at least initially. Reinforcing it, the furlough of 800,000 federal employees should make economic measures look worse than otherwise, although follow-on economic effects, on government contractors for instance, would hardly develop in a short-lived shutdown, even one as long as occurred in 1995. Once the shutdown ended, the risk-averse investment pattern would reverse, reinforced by the ensuing economic improvement as the furloughed federal workers go back to work and likely also collect back pay.

Anticipating such a pattern, the troubles would then create a buying opportunity in risk assets. It would, of course, not exist were not risk assets otherwise already fundamentally attractive. But with equity valuations favorable even before this trouble began and those on more credit-sensitive bonds, including municipals, also more attractive than higher-grade paper, the temporary alarm surrounding Washington's dysfunction improves the opportunity for a buy. Reinforcing the case is the assurance that the Federal Reserve will maintain an ongoing flow of liquidity throughout and that the credit rating agencies will probably hold present ratings on the government constant. After all, only Fitch has a negative outlook. Moody's and Standard & Poor's both have stable outlooks.

On the lower probability that this mess lasts longer, the negative ramifications for risk assets become more real and less susceptible to a quick reversal. Such a prospect, however, would take a long shutdown indeed. Even if problems lasted a month, the economic and market comeback after a resolution would likely more than make up for the economic and price losses otherwise suffered. Should the problems extend much longer than a month, however, this last quarter of the year would weaken economically and the flight from risk in financial markets would characterize the quarter generally. If problems were to last longer still, the adverse economic consequences would spread. Contracts would be cancelled and layoffs would extend far beyond federal employees. Consumer and capital spending would suffer accordingly. The risks of outright recession would rise substantially, and the prospects for risk assets would take on a fundamentally negative character.

Though still a low probability, such an outcome is of course possible. Washington has already deviated from what had become a long-lasting pattern. But such events would also be unprecedented and are, accordingly, unlikely. In their absence, the probabilities favor risk assets and using any near-term reverses as a buying opportunity.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/ or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Bond prices move inversely to interest rates: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. No investing strategy can overcome all market volatility or guarantee future results.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett

Read more commentaries by Lord Abbett