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Slowdown Shutdown
Toronto: October 06, 2013
By John Stephenson

Just as the U.S. economy seemed to be turning the corner, squabbling politicians decided to shift things into a lower gear by shutting down the federal government and furloughing 800,000 federal workers. As a result of the budget impasse, parts of the federal government have been closed since October 1st as Republicans in the House of Representatives insisted that they would not approve new funding of the government unless there were significant changes made to Obamacare, the President’s landmark 2010 healthcare law.

With just ten days left to reach a separate agreement on the debt ceiling or risk defaulting on America’s debt, investors are growing increasingly uneasy about the continuing political shenanigans in Washington. The current shutdown in Washington is not a good omen for the October 17th deadline when according to the U.S. Treasury the country will run out of ways to pay the bills unless lawmakers can come to an agreement to raise the nation’s borrowing limit. And that uncertainty is being felt in the stock market, with the S&P 500 down around three percent from its recent record close.

But despite the modest stock slump so far, failure to raise the U.S. debt ceiling poses a significant risk to the economy and the stock market. Recent history shows lawmakers sometimes need a sharp fall in stock prices to focus their minds. At a minimum, politics is throwing a monkey wrench into the economy just as things were finally beginning to hum after the financial crisis of 2008/2009. Companies have returned to profitability and are hiring again, albeit slowly, but the next phase of the recovery will require a leap of faith: investment. And it takes a bold executive to commit hard earned dollars to an uncertain future, particularly when they have no idea what tax or regulation Washington might change and politicians insist on a brinkmanship approach to budgeting.

Federal shutdowns have been far from rare occurrences with 17 such shutdowns since 1976, when the budgeting process started taking on a more partisan flavour. In part this more partisan politics reflects the change in how political parties are financed. In the past, the Republican Party was the party of big business. But increasingly groups such as the National Federation of Independent Business and the Chamber of Congress have been losing their hold on the party. Deep-pocketed and ideologically driven outfits such as the Heritage Foundation, which advocates for a smaller government, have become much more influential on the political scene.

While most slowdowns have lasted an average of eight days, the current slowdown shows no sign of wrapping up quickly. In the most recent ten disruptions, the S&P 500 reclaimed all of its losses, and typically a bit more, in the subsequent two months. During Jimmy Carter’s presidency there was even a technical default forcing the government to make up the missed coupon payment to bond holders later.

There is no doubt that the current slowdown is having an effect on the market and the Federal Reserve, which is unlikely to taper anytime soon. With the Fed on hold, this is a plus for bonds and for rate-sensitive equities. The sector that has been the big loser so far are the shares of defence and other contractors which plunged by 8% as Washington’s doors closed. This may be just the beginning of the bad news for defence firms however, as further spending cuts are due in January under sequestration.

Earnings season kicks off on Wednesday with the financial sector expected to continue its winning ways. According to data from tracking firm FactSet, the Financials should see a 3.2% rise in overall earnings. While a 3.2% growth in earnings is pretty good, particularly when the economy overall is likely to grow less than 2 percent during the quarter, it’s still just half the pace envisioned three months ago. Information technology, Energy and Healthcare sectors are expected to disappoint this quarter.

With no end to the slowdown in sight, I am expecting market volatility to peak over the next week as the debate over the debt ceiling looms large. While there will undoubtedly be some tough days ahead for investors, it seems inconceivable that policy makers will not act to avoid a calamitous default on the national debt. For my part, I’m looking at the week ahead as a particularly attractive time for bargain hunting.

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