Key Points

  • US Federal government partial shutdown is now the longest on record, with rising direct and indirect costs to the economy each week that will weigh increasingly more on growth and sentiment.
  • This problem can be quickly (and even potentially easily) solved, which would be a positive catalyst for US growth outlook and risky assets.
  • We believe that US equity markets are not pricing in growing implications for US growth. We are taking advantage by rotating towards low volatility equities.

Background: How does the US Federal government actually ‘shutdown’ and what does that mean?

The US Federal government operates on a 30th September fiscal year. By 1st October 2018, Congress had passed five out of twelve appropriation bills which determine discretionary spending for the current fiscal year (ending 30th September 2019).

By law, the Federal government is not allowed to make expenditures unless there is legislation agreed (by the House, the Senate and the President) that identifies the scope of expenditures and the source of funding, whether through new revenues or new borrowings. The origin lies in the Constitution but was refined further by Budget Process laws enacted in 1974 that shifted control of the budget from the President to Congress. This revision prohibited Federal agencies from incurring any cost (or inducing volunteered cost or labor) that has not been agreed by law. Consequently, in the absence of agreed legislation or a Continuing Resolution (CR, or an agreement to maintain existing spending for a limited period), there is a Funding Gap for specific US Federal agencies.

This is not the first time that the US Federal government has entered a shutdown phase. Since the new rules put in place in 1974, this has occurred more than twenty times, as Table 1 shows. Some Funding Gaps persisted for a day or less. Some were caused by genuine disagreements and others for trivial matters. One (30 September 1982) was caused by Congress not finishing legislation in time due to social engagements – the Republicans had a barbeque at the White House with President Reagan and the Democrats had a high-priced fund-raising dinner. Another (9 February 2018) was caused by one Senator engaged in a protest filibuster that forced the deadline to be missed.

Previously, when a shutdown occurred, Federal agencies continued operating as normal, presuming that Congress would not want the government to stop. However, in 1980, the US Attorney General made explicitly clear (supported by US Federal Court opinions) that any violation of this would subject the heads of Federal Departments (and other managers) to criminal prosecution and jail. The US Attorney General also mandated that each Federal agency prepare procedures to reduce the scope of the Federal government’s activities in the case of future Funding Gap. Each Federal agency operates according to their own contingency plan.

Exceptions include any Federal government activity involving “the safety of human life or the protection of property” who are deemed “Essential personnel”. “Essential personnel” operate as normal but without pay. “Non-essential personnel” are not allowed to work and are put on immediate unpaid leave. “Exempt personnel” are those whose pay is not directly tied to a Federal budget – e.g. contractors.

Typically, back-pay is restored once the Funding Gap has been addressed and the Federal government is back to normal operation. However, this is not guaranteed. Not all Federal agencies are impacted in a shutdown – only those whose funding is directly curtailed by the legislation of the moment.

Table 1: Prior US Federal Government Shutdowns

Today: How large is the current US Federal government shutdown?

The current shutdown is tied to spending legislation that covers roughly 800,000 of 2.1mm Federal employees. The specific Federal agencies whose budget funding has not been legislated into law are detailed in Table 2 (below).

The current shutdown is the longest one on record at 26 days. More importantly, there does not seem to be any progress on reconciliation between the Democrats and the US President. In fact, the tone and tenure of recent meetings has deteriorated.

The heart of the current disagreement is funding to build “The Wall” on the border between the United States and Mexico. Congress has offered $1.3bn to fund border security whilst President Trump demands at least $5.0bn. Even in December 2018, when the Republican Party controlled both the House and the Senate (with a Republican President), there were not enough Republican Senators to pass an appropriations bill that included the full $5.0bn in funding.

The disagreement between Congress and President Trump escalated quickly over December 2018, resulting in the failure of Congress to pass the appropriation bills shown in Table 2.

In a nutshell, any legislation must be proposed and passed in the House, then passed in the Senate (or sent back to the House), and finally approved (or vetoed) by the President. On 3rd January 2019, the House went into Democrat control. The Senate (Republican) Majority leader stated that the Senate would not put any appropriation bill to a vote that the President would not sign into law.

As of today, there has been no agreement on legislation that would pass the Senate.

Consequently, on 22nd December 2018, the US Federal government shut down all but essential operations for the nine Federal agencies and related departments shown in Table 2. Non-essential Federal employees are furloughed and all Federal employees (420,000 essential and 380,000 non-essential) stop receiving pay checks.

Table 2: Prior US Federal Government Shutdowns

Why is the current US Federal government shutdown important for markets?

Even a partial Federal government shutdown has an economic impact. The direct costs are three-fold: paying employees (eventually) not to work, uncollected fee revenues, and penalty interest rate on late payment. The second order impact grows over time. Consultants and contractors are not paid during a shutdown, which would lead them to curtail or defer work. Many US State governments rely upon Federal transfers for funding local programmes. These transfers will be reduced, requiring US State governments to find offsets or cut services. Consumer confidence will ultimately be impacted, particular in those regions with a high proportion of those impacted Federal employees or (importantly) contractors.

This shutdown has an indirect impact in other ways. If the shutdown progresses over one month, then it potentially impacts distribution of transfer payments – e.g. food stamps (SNAP), subsidies to the agriculture industry, or other transfers to US States. The shutdown also limits, if not halts, regulatory reviews and corporate actions given that both the FCC and the SEC are closed. Of note, the US Coast Guard, immigration courts, oil & gas lease approvals, food inspectors and US Federal courts are shut, or on very limited service. The Internal Revenue Service is also impacted, with potential implications for tax revenue assessment and collection.

Market participants will be quick to note that the US Commerce Department is shut, which impairs the release of various data items (e.g. new home sales, trade balance, factory orders & inventories, construction spending) as well as the US Department of Agriculture (e.g. CFTC’s Commitment of Traders report, commodity supply and demand estimates). Fortunately, the US Labor Department remains open and continues to publish employment data.

Market estimates for the GDP impact of the shutdown start at 0.1% to 0.2% of GDP, should it be resolved quickly. Should the shutdown progress beyond four weeks, the impact starts to increase meaningfully. The Federal government analysis of the 16 day Federal government shutdown in 2013 estimated the GDP cost at 0.2% to 0.6%. Today’s economy and government are bigger, so the absolute cost is likely already similar if not larger.

Last Friday, Standard & Poor’s estimated that the direct costs of the current shutdown to be $3.6bn already, rising to $5.7bn by the end of January and escalating faster from that point. S&P notes that real GDP growth would be reduced by 0.1% for every two weeks that the partial shutdown persists. The direct costs should reverse if all back-pay is recovered. However, this ignores the indirect costs of reduced spending and deferred payment and work by impacted contractors. Various economists (e.g. Bank of America, Morgan Stanley) note that the costs start to grow significantly after one month as spending habits change.

Portfolio Implications: Tepid but Positive View on US Growth, but Events Could Change Quickly

We think that the US Federal government shutdown and the US-vs-China trade disputes remain the two most important – and potentially most quickly solved – factors impeding macro-economic growth and asset prices. Both of these factors present material upside or downside risk to US and global growth. Equally important: both of these factors can be resolved quickly through agreement between two parties.

Consequently, the Sandaire Investment Committee views the combination of US-China tariff discussions and the US Federal government shutdown (or President Trump vs. Democrats) to be the most impactful unknown variables impacting US economic growth. Importantly, both of these factors can be resolved quickly and, should that occur, would be positive for risky assets.

We note that US equity and credit markets have not reacted meaningfully to the ongoing Federal government shutdown, despite dominating headlines. We also believe that a prolonged US Federal government shutdown will eventually impact global equity markets and risk premia. As a result, we have continued to take advantage of this opportunity to rotate into lower-volatility equities, in line with our Neutral outlook on global equities.

Sandaire Investment Team