Should Investors Care About the Government Shutdown?

News of the government shutdown has dominated the front pages in the last few days. Gone are concerns about the end of the Federal Reserve's quantitative easing as Americans wait to see whether their government will close for the first time in 17 years at midnight tonight. Over the weekend, the House sent back a stopgap funding bill that would keep the government open, attaching to it a one-year delay to the new health care law and a repeal of the medical-devices tax. The Senate is expected to send back a clean bill today stripped of the Obamacare language, making a shutdown highly likely. The Dow Jones Industrial Average (^DJI -0.21%) has already retreated 4% since it peaked on Sept. 18 following the Fed's "no taper" decision, and is likely to fall some more if Washington closes down. Should long-term investors care about this crisis? Let's look at both sides of the debate.

Caution: Volatility ahead. Source: Wikimedia Commons.

Yes, this is an outrage
Speaking to the public on Friday, President Barack Obama warned that a government shutdown would cut off vital services from many Americans and "would throw a wrench into the gears of our economy at a time when those gears have gained some traction."

Estimates on the actual economic effects of a short-term shutdown vary, but most of them are relatively minor. Macroeconomic Advisers estimates that a two-week shutdown would knock 0.3% off the GDP this quarter, but the economy would make up for the loss in the first quarter of next year. Other estimates are worse. Moody's economist Mark Zandi said a three- to four-week shutdown could shave 1.4% off this quarter's GDP.

Notably, during the last two government shutdowns, in 1995 and 1996, stocks were hardly affected, actually gaining 1.3% the first time and 0.1% on the second occasion. That was in a much different era, however, in the midst of a tech boom. Today's economy is much more fragile, with unemployment still abnormally high.

The bigger issues with the budget standoff may be symbolic. With the Treasury running low on cash, Congress will need to raise the debt ceiling by Oct. 17, or the country may default on its debt -- an event economists say would be catastrophic. A delay in the budget resolution only makes a debt ceiling compromise seem more difficult. The U.S. dollar is the world's reserve currency and a foundation for global capital markets. As Obama said in his speech: "We don't fully understand what might happen, the dangers involved, because no Congress has ever actually threatened default. But we know it would have a profound destabilizing effect on the entire economy, on the world economy, because America is the bedrock of world investment." Even the threat of a default will likely roil the market, as seen in 2011 when a delay in raising the borrowing limit cause Standard and Poor's to cut the country's "AAA" credit rating and the Dow fell nearly 2,000 points.

No, this is business as usual
Investors saw a similar standoff at the end of last year when both parties refused to compromise to avoid the automatic tax increases and spending cuts that would go into effect with the new year. The Dow fell about 3% during the last two weeks of the year but rebounded quickly in 2013 once an agreement was made. A short-term drop in stocks also presents long-term investors with a buying opportunity, as the recent all-time highs have made cheap buys scarce. The mantra "Be greedy when others are fearful, and fearful when others are greedy" seems as applicable as ever. Considering the other crises the stock market has survived -- two world wars, the Great Depression, a terrorist attack, the financial crisis, etc. -- to deliver a long-term annualized return of 6%, it seems the government shutdown is just a blip on the radar.

The dual closures of 1995 and 1996 lasted nearly four weeks and furloughed close to 1 million workers, but they only trimmed 0.25% in GDP and cost the government $2 billion. That may seem like a large sum, but compared to corporate America, it's minimal. Dow stocks regularly gain or lose that amount in market value in just one day.

Let's see what the Fed does
Perhaps the one economic decision that will be affected by the congressional shenanigans is the one that has fallen off the radar. The Federal Reserve's Open Market Committee is set to meet at the end of October to again consider cutting its $85 billion monthly bond-buying program. Fed Chairman Ben Bernanke has excoriated Congress time and again for failing to act to boost the economy, focusing on short-term spending cuts instead of long-term growth. Bernanke seems to see part of his job directing monetary policy as compensating for weak fiscal policy. Further breakdowns on the congressional side are only likely to extend the bond-buying program.

And the winner is...
The government shutdown is certainly nothing to cheer about, but its long-term effects on the market seem to be relatively contained. The greater concern to investors may be the message that the shutdown sends. At a time when the U.S. is trying to assert its leadership in Syria and has suddenly opened a new channel of communication with Iran, a shutdown would be a national embarrassment. It also marks yet another low point for a Congress that has cost the U.S. its "AAA" credit rating and, with single-digit approval ratings, is considered by many to be the worst group of legislators in the country's history. With the debt-ceiling debate unlikely to be resolved overnight, any delay in the passing of a budget only wastes critical time to work to lift the borrowing limit, whose breaching would be a disaster for financial markets and the economy as a whole.

Wall Street hates uncertainty, as do the corporations responsible for doing much of the nation's hiring. Eleventh-hour debates on what used to be routine legislative business and games of budgetary chicken do no favors for the economy, only serving to chip away investors' confidence in the government. A short-term shutdown will likely be nothing more than a speed bump, but an extended closure could have far-reaching consequences -- highest among them the threat of default.