Investing During the Shutdown: Welcome to the ‘Land of Oz’

Washington is ‘run by the Munchkins,’ Citigroup’s Buiter says

The Lincoln Memorial and other monuments are closed to the public. (Photo: AP) The Lincoln Memorial and other monuments are closed to the public. (Photo: AP)

Congress failed to strike a deal late Monday that would have kept the government funded, pushing the government to partially shut down on Tuesday and forcing about 800,000 federal workers off the job. (The last shutdown took place in early 1996.)

The current shutdown means that most nonessential federal programs and services are suspended — such as national parks and museums, NASA and the Environmental Protection Agency — while military employees, air traffic controllers, food inspectors and postal staffers keep working.

Mid-day Tuesday, President Obama delivered a speech in the Rose Garden, urging lawmakers to pass a budget that end the impasse. "We're better than this," the president said.

The markets, anticipating a short-term shutdown, rose slightly Tuesday, and gold weakened for a second day in a row.

Still, some experts couldn’t contain their frustration at the gridlock in Washington.

Citigroup (C) chief economist Willem Buiter compared the United States to the "Land of Oz run by the Munchkins" during an interview with CNBC on Tuesday. If (or when) the stock markets become concerned about the debt ceiling and the chance of a sovereign default, the shutdown “could become an economic disaster," Buiter said.

On Monday, Standard & Poor's warned that a deal must be reached by Oct. 17 or the Treasury would likely miss debt repayments and default on the country’s roughly $17 trillion national debt, which would hurt the country’s rating.

"If the U.S. is to default on even a small portion of its debt, it could pull the rug under the global economy," explained Buiter on CNBC. "U.S. sovereign debt is the linchpin of the global economy."

The way out of such an impasse, says Raymond James (RJF) economist Scott Brown, is for the Senate to come up with a bill that can win a majority vote in the House, perhaps a short-term continuing resolution or longer-term agreement.

“In the meantime, the impact on the economy and the financial markets will be a function of how long the government stays shut,” Brown noted. “Debt ceiling negotiations loom following any agreement on the budget.”

Partial shutdowns of the federal government cost the U.S. at least $300 million a day in lost economic output, according to IHS Global Insight. Furthermore, the research group projects that a weeklong shutdown would push its forecast of 2.2% annualized growth in the fourth quarter down to 2%.

Analysts at Janney Montgomery Scott anticipate a 21-day shutdown might weaken growth by 0.9 to 1.4 percentage points, according to a Bloomberg report.

Portfolio Picture

The ’96 shutdown was unpopular with voters, says Wells Fargo Advisors chief macro-strategist Gary Thayer, and hurt Republicans in the next election cycle.  

“Therefore lawmakers probably want to avoid a prolonged shutdown that could do similar political damage ahead of next year’s midterm elections,” Thayer wrote in a report on Tuesday.

Given the political pressure on Congress to make a deal, Wells Fargo Advisors is not changing its short-term economic or market outlook, according to Thayer.  

“This could be a short-term event,” he explained. “But a long-term shutdown would obviously have a negative impact on the economy, which could change our economic outlook and stock market targets.”

Other observers agree.

"None of the government shutdowns since 1976 produced chaos in financial markets or prolonged speculation of default," said Rod Smyth, chief investment officer of Riverfront Investment Group, in a note to clients. Smyth added that his firm has not become defensive or moved to raise cash, so far.

Raymond James chief investment strategist Jeff Saut, along with Smyth and others, sees the market moving higher once the political impasse is over.

“I think the stock market is sufficiently oversold and will attempt to rally from here,” Saut said in a note early Tueday. “But, [the S&P 500] needs to stay above 1,684 to convince.”

Matt Coffina, editor of Morningstar StockInvestor, reminded investors in a video report posted Monday that during the threat of an earlier shutdown, the market “sold off quite a bit … and then the market rallied right back when it didn't actually happen.” 

Investors should expect “some elevated volatility in the near term here,” Coffina explained. “But overall, I don't see any reason to go run out and panic and sell all of your common stocks. I'm certainly planning to stay the course with StockInvestor's portfolios.”

Like others, Coffina acknowledges that shutdowns can hurt demand and hence, the economy, but “in the grand scheme of things," he says, "I think it's very unlikely that this budget impasse is really going to result in a material decrease in intrinsic value.”

Silver Linings

Veteran Washington watcher Andrew Friedman says he’s been expecting market volatility related to the “twin deadlines of funding the government and raising the debt ceiling” for some time.

The volatility, explains the principal of The Washington Update, should be short-lived — and could offer investors a silver lining.

“This is not to suggest that investors should sell equities in anticipation of a downturn, because they will not know when a compromise is imminent so they should buy back in,” the former attorney wrote in his Tuesday outlook. “But market volatility due to a perception of Washington dysfunction could be a buying opportunity.”

According to LPL Financial (LPLA) chief market strategist Jeffrey Kleintop, history "tells us [a shutdown] is not necessarily a bad thing for investors. The 16 government shutdowns over the past 40 years that have ranged from 1 to 21 days have not been particularly negative for stock market investors, averaging only a 2% decline for the S&P 500.

"More importantly, from a longer-term perspective they preceded above-average returns," Kleintop added in his Oct. 1 commentary. "The S&P 500 Index has risen 11% on average in the 12 months following the shutdowns, above the 9% for all periods. Notably, in the last government shutdown that took place 17 years ago in late 1995, the S&P 500 rose 21% in the following year."

The rise in stocks on Tuesday, after their weaking on Monday, "makes sense since given the long history of investor behavior around these events. and [the fact] that selling stocks on Washington's fiscal battles has been costly for investors in recent years as short term declines gave way to rallies," he explained.

Plus, the VIX, or volatility index, is currently around 16, not the 48 seen in August 2011, Kleintop shares, "when the debt ceiling was last the subject of a battle in Washington and stocks fell 17%."

Still, while it's good news that the markets are steady, a strong negative market reaction puts more pressure on politicians to compromise, the expert points out. "We continue to monitor events closely, but believe this is not a time for indiscriminate selling but instead for looking for opportunities to buy on weakness," he said."

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Check out Government Shutdown Threatens Growing U.S. Wealth on ThinkAdvisor.

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