The country appears to be stumbling toward a government shutdown as the authorization for funding runs out starting October 1. This would be the 22^nd government shutdown since 1976, so one can take a look at the historical implications. While shutdowns can cause disruptions, the impact on the economy and markets has been modest in the past, with most economic activity delayed but not lost. And historically markets have been driven by the broader economic and earnings environment, not the temporary shutdowns.

Economic impact

The effect on the economy depends on how long any shutdown would last. The longer the shutdown, the greater the cumulative impact. The length of shutdowns has varied widely, with several lasting just a day and the longest lasting 35 days. The average is about a week.

Economists estimate a government shutdown would lower gross domestic product (GDP), a broad measure of the economy, by about 0.2% of annualized quarterly growth per week that the shutdown lasts. That’s a relatively moderate impact. For perspective, the latest estimate of second quarter GDP shows the economy grew at a 2.1% annualized rate. About half of the impact to annualized economic growth, however, would reverse once the shutdown ends as spending resumes and catches up.

Shutdowns impact the economy in a few ways. There are about 2.2 million federal employees who would not be paid during the shutdown. However, the federal workers always have been paid retroactively after a shutdown ends. Also, payments to government contractors would be delayed but ultimately resumed. The key here is that if spending drops when employees or contractors are not paid, it’s largely delayed and not lost economic activity.

Part of the impact of a shutdown, however, results in a permanent economic loss, largely from the lost output of government employees not working, and knock-on impacts on the private sector. Around 800,000 to 900,000 federal employees likely would be furloughed and not work. Some government employees, however, would continue to work as they are considered essential, such as the military, food safety inspectors, air traffic controllers and others. Also, it’s important to note that Social Security, Medicaid and Medicare are considered mandatory spending and are funded.

A shutdown, however, would come at a time when there are other moderate economic headwinds, including higher interest rates, rising oil prices, a broadening strike by auto workers and the resumption of student loan payments. It’s also possible an extended shutdown could dent consumer and business confidence.

Additionally, Moody’s rating agency may lower its rating of U.S. government from its top Aaa rating, following Fitch’s downgrade earlier this year and S&P’s downgrade in 2011. The market expects the downgrade, and Fitch’s downgrade earlier this year had minimal market impact.

Market

Government shutdowns historically have had a limited and fleeting impact on markets. Market volatility can increase temporarily but other market-driving factors, like the path of the economy, interest rates, and corporate earnings dominate over time. We expect this trend will hold through any shutdown this year.

On average, the 10-year Treasury interest rate has fallen moderately during shutdowns as some investors seek safety, driving up Treasury bond prices, which lowers the yield. The performance of stocks also has varied during shutdowns but generally has resulted in only moderate gains or losses. The S&P 500 index has risen about 55% of the time with an average return that’s slightly positive. Returns have varied from a more than a 4% loss to a gain of more than 10%, which occurred during the shutdown that ran from December 2018 into January of 2019.

The shutdown of 2018/2019 is informative because in that circumstance, Federal Reserve (Fed) interest rate increases had roiled markets until late December when the Fed signaled it would likely pause rate increases. The change in tone from the Fed helped spark the rally.

Markets heading into the possible October shutdown to date have been volatile, with both equity markets and bond prices falling. The primary drivers of the markets have been increases in interest rates, expectations that the Federal Reserve will keep its target interest rate higher for a long period, and concerns about the impact of higher interest rates on economic growth. News of a government shutdown is not driving markets because it’s understood that shutdowns historically have had minimal lasting economic and market impact.

Markets could become concerned, however, if the shutdown drags on and delays releases of key economic data. Markets have been closely scrutinizing the economy for signs of a significant slowdown or reacceleration of economic growth and inflation. Key data due to be released over the next few weeks could be delayed with an extended shutdown, including employment and inflation figures. This could create a bit of fog and increase the importance of the broad array of data from non-governmental sources, such as employment figures from payroll processer ADP.

While government shutdowns can spark headlines and fuel the news cycle, the economic and market impact over time is low. Ultimately, we expect Congress will fund the government at the levels agreed to earlier this year when the debt ceiling was suspended until 2025. And markets will continue to focus on what matters most – the forward path of the economy and corporate earnings as influenced by the Federal Reserve and other factors.

As always, consult your financial advisor for advice on your particular needs.