David Joy: Investor confidence hangs in the balance as political stalemate drags on

The government shutdown has already persisted for longer than many thought likely just a week ago. Judging from comments made on the Sunday morning news shows we are not close to a resolution. This makes it more likely that the budget discussion eventually merges with the debt ceiling deadline of Oct. 17. And despite assurances to the contrary, the possibility of a government default rises as a result.

The likelihood of a default still seems remote, but only so because the underlying assumption is: Politicians cannot possibly be foolish enough to let that happen, can they? However, it cannot be dismissed entirely. Treasury has warned that a default would be catastrophic, but there is certainly a healthy dose of partisanship in their assessment.

Nevertheless, a default puts us in uncharted waters. The market reaction that would follow is unknown. And even if it was quickly reversed, the damage to investor confidence that would result is difficult to quantify.

In one piece of good news for the economy, furloughed workers will receive back pay and civilian Department of Defense workers will largely remain on the job, muting the economic impact of the shutdown.

So far, the market reaction to the shutdown has been fairly muted. Through the first four days of the shutdown, ending last Friday, the S&P 500 was actually up 0.5%, and the ten-year Treasury note yield was higher by four basis points.

However, such relative complacency is unlikely to prevail should the political stalemate persist. Indeed, in early trading on Monday, the S&P 500 was sharply lower and the ten-year yield was down four basis points, as last week’s benign reaction started to wash away. Overseas markets also traded lower as the world scratches its head at the standoff in Washington.

Shutdown clouds the economic picture
As much as investors might like to focus on economic fundamentals, that effort is being impaired by the shutdown. Last Friday’s scheduled release of the September employment report was postponed, leaving a void in the most closely watched indicator of all in this era of quantitative easing. Other reports will be impacted as well. Privately compiled reports will continue to be produced, but the full array of data will be delayed, making an accurate assessment of current conditions more difficult.

Although relatively little has been said about earnings while the focus has been on the shutdown, third quarter reports commence this week. Expectations are that earnings will have grown in the vicinity of +/- 3% compared to last year’s third quarter. That would represent a slim improvement from the results in the first half of the year. But how the government shutdown impacts forward guidance will be closely watched. Confidence in Washington was not exactly running high in corporate America even before this latest partisan standoff.

All of which makes this political distraction that much more disappointing. This was widely expected to be the point in time when economic growth would find some traction, abetted by signs of improvement overseas, pushing the U.S. economy toward a sustainable pace of 2.5% growth, and allowing earnings to deliver on the expectations of improvement embedded in forward projections. And even despite their often overly optimistic expectations for the pace of economic growth, it was also anticipated that the Fed would view growth as sufficiently robust to allow tapering to begin. Now, however, these expectations are taking a back seat to the drama in Washington, a drama that doesn’t have to happen.

If the most troublesome outcome is avoided, the economy can continue to improve, and earnings can grow. There is still plenty of time for this impasse to be resolved before the debt ceiling deadline is reached. But each day that passes without progress toward an agreement will see investor and consumer nervousness rise. If the experience in August 2011 is any guide, then we can expect economic activity to come to a standstill until the outcome and its ramifications become clear. When they did back then, the economy recovered as it put that episode behind it. Back then, we avoided a default at the eleventh hour. The government’s credit rating was downgraded by Standard & Poor’s, but life went on. If we avoid default this time, the response might be the same. But if we don’t, the reaction could be quite different.

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