Investment Strategy Brief:
Yet Another Potential Shutdown

Below is a transcript of this week’s video.

Hi, this is Jason Pride, Chief of Investment Strategy and Research at Glenmede.

As we enter this week, another potential government shutdown looms with congress again racing to beat an artificially set clock for fiscal compromise. Over the weekend, newly promoted House of Representatives Speaker Mike Johnson proposed a two-step continuing resolution which provides another round of temporary spending extensions to two different January and February deadlines for different portions of the government’s spending.

The proposal is already facing opposition from both sides of the isle for the concessions it requires, highlighting the chance for a tense round of negotiations this week and yet another chance of a government shutdown. Before we get to twisted in our seats , it is important to note that government shutdowns have historically provided a negligible to modest impact on the economy. Since 1978 there have been 15 shutdowns, with the longest lasting about 35 days and causing a quarter-percent headwind to GDP between the 4^th quarter of 2018 and the 1^st Quarter of 2019. A prolonged shutdown, however, could intensify the effect, as furloughed federal workers reduce their spending and federal expenditures are paused.

A primary driver of these risks is the current primary spending deficit of near 3% of GDP (shown in light grey), which has driven an accumulation of debt, on which the government must also pay a growing amount of interest (shown in a darker blue). It is expected that this dynamic will compound into a bigger problem over time if efforts are not made to contain the spending.

Earlier this year, credit rating agency Fitch downgraded U.S. Debt from AAA to AA+, on the basis of expectations of further fiscal deterioration, an increasing debt burden, and contentious policymaking. Moody’s, the last of the major three credit rating agencies to keep the U.S. at a AAA rating, last week shifted their outlook on their credit rating to negative from stable, hinting at the potential for a downgrade.

So, the risk of a downgrade is real, but how much of a risk is this? Well, a quick survey of the landscape of sovereign debt across the globe, as shown through this country choropleth, and one will quickly realize that there is a full range of ratings from AAA at the top down to countries in difficulty with C and D ratings. The United States, after Fitch’s downgrade, remained the largest AA-or-better pools for fixed income investing in the world, limiting the option for investors to find enough alternative options elsewhere.

For this reason, most if not all of the movement in the yield on longer duration U.S. government debt like U.S. 10-year Treasuries is due to changes in short-term rates and expectations for short-term rates, which are primarily driven by the Federal Reserve’s rate hike campaign.

Still, the rapid rise in the cost of borrowing and the pace of new treasury issuance, debt servicing costs are rising as a % of the government budget for the first time in 35 years, and are expected to get close to 15% of the government’s budget within the next two years. At similar levels in the 1980’s, the U.S. government responded with a series of legislation to contain spending. As a result, we are unlikely to see this shutdown negotiation resolve this issue long-term. This will likely be a going theme for the coming years.

So to summarize, another potential government shutdown looms again this week, but is more likely to have a theatrical effect than a near-term economic one. The primary driver behind the recurring shutdown debates is the unsustainable path of the U.S. Government budget. Moody’s now “negative” credit-rating outlook for U.S. debt points to a likely downgrade from AAA to AA+ like Fitch’s. The rise in yield on 10-Year Treasuries reflects the rise in shorter-term rates more so than credit risk. While the looming government shutdown is likely to be resolved near-term, growing fiscal pressures will likely lead to recurring negotiations.

Thanks for listening! And please don’t hesitate to reach out with any questions.