Our reaction to the government shutdown

By Margaret MacCarthy Bacon

The last government shutdown, which spanned Christmas and New Year’s in 1995-1996 lasted for 21 days and is estimated to have cost taxpayers $1.4 billion. It was the longest government shutdown in history. During that shutdown, the S&P 500® Index fell 3.7%, but quickly rebounded after government employees returned to work.

There have been 16 other shutdowns dating back to 1976, which ranged from one day to 18 days, so it’s hard to estimate the impact of this year’s drama until politicians in Washington actually reach an agreement. Economists estimate that even a short shutdown — of three or four days — would begin to trim several decimal points off economic growth. A longer shutdown of three or four weeks would have a more detrimental effect. Of greater concern to us is that a government shutdown would lead to increased debate regarding the debt ceiling. Although we feel it is likely that the debt ceiling will be raised by mid-October, it is an issue that we will be monitoring closely.

Unless otherwise noted, the source for all data above is Bloomberg.

The views expressed represent the Manager’s assessment of the market environment as of October 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views.

By David Hillmeyer

Despite the headline-grabbing news pertaining to a U.S. government shutdown, shutting down the government isn’t a new political tactic to investors. The current furloughing of nonessential government employees, for example, is the 17th such shutdown the federal government has undertaken over the years. However, a difference between recent closings and those of years past is that these discussions are playing out through the media rather than behind closed doors on Capitol Hill. Both sides of the aisle are using tactics that limit the other’s willingness to negotiate. 

Republicans are choosing to include spending cuts to the Affordable Care Act as part of their bill, while Democrats are refusing to negotiate to limit the items added to the debt ceiling. We should continue to monitor polling data for signs that each party’s popularity is taking a hit because, in our opinion, shared blame would increase the likelihood of the two sides coming together. Our base-case scenario, however, is that a resolution will be realized without the country defaulting on its debt. Nevertheless, the partisanship observed since, and prior to, the shutdown leaves tremendous uncertainty.

To this point, market participants seem to be assuming that Congress will pass a continuing resolution (CR) that will allow the government to reopen soon and address the debt ceiling prior to expiration. We can observe this complacency by evaluating the small change in risk premiums for fixed income asset classes. For instance, the Barclays U.S. Corporate Investment Grade Index has priced within a three-basis-point range for the past three weeks (one basis point equals a hundredth of a percent). Ten-year Treasury yields remain within five basis points of where they were in mid-September. Furthermore, the S&P 500® Index is within 3% of its record close (reached in September 2013). These patterns of low volatility could likely wane, however, if nothing remains resolved as we approach the debt ceiling cutoff. 

We have already observed an increase in the Chicago Board Options Exchange Volatility Index (VIX), which has experienced a move higher of nearly 50%, or about six points since Sept. 18, 2013. Additionally, the T-bill market is exhibiting signs of stress, with October maturities now yielding more than 0.25%. This is more than 20 basis points higher than late-November T-bills. From a pricing perspective, the T-bill market is showing some similarities to April 26, 1979, when the U.S. Treasury Department temporarily missed making payments on certain short-term maturities due to what it claimed were operational errors.

The closer we get to the looming debt-ceiling date established by the Treasury Department, the higher the probability, in our opinion, that we will see a CR bill passed, combined with an increase in the allowable borrowings. In recent days, the White House has intimated that the administration would entertain an increase in the debt ceiling to a date that is shy of its original demand. Although this would address any immediate concerns regarding a default, the temporary nature of the resolution could likely lead to increased market uncertainty and higher volatility.

As is, however, the shutdown should negatively impair fourth-quarter U.S. gross domestic product figures. This will likely have an impact on the Federal Reserve’s willingness to begin reducing the pace at which it purchases mortgage-backed securities and Treasurys. At this point, we could see the so called “tapering” program get pushed into 2014.

In the event of an actual default by the Treasury, risk assets should experience significant selling pressure, with U.S. equities leading the market lower. The immediate reaction in the Treasury market is a bit more uncertain and, contrary to what many believe, we may actually see 10-year yields migrate lower.

Given the nature of today's political crisis in Washington, D.C., positioning for one particular outcome is very challenging. Given the potential outcomes, taking extreme positions is probably not warranted. However, for those concerned about a default and a subsequent selloff of higher-beta (riskier) assets (high yield or equity investments, for example), credit volatility is low and, as a result, we believe credit hedges may be one cost-effective portfolio consideration during this period of uncertainty.

The views expressed represent the Manager’s assessment of the market environment as of October 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views.

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Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

The Barclays U.S. Corporate Investment Grade Index is composed of U.S. dollar–denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least one year to maturity.

The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.

The Chicago Board Options Exchange (CBOE) Volatility Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.


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