Is the US shutdown bullish or bearish?
A reader recently asked me what I thought about the effect the government shutdown would have on asset markets. Obviously, I have no crystal ball but here are some thoughts. The dearth of safe assets is key.
US government bonds: the key developments for bond markets are two-fold. First, every day we have a shutdown, we erase $300 million from US GDP. As the shutdown is in a third day, we have already lost nearly $1 billion in output. Factor in negative externalities and you get in the order of 0.3% down (see estimates here). A 15- to 20-day shutdown gets you to about zero growth for the US economy in Q4. That’s when negative externalities from reduced mortgage approvals, consumer retrenchment, and reduced business sentiment start to add up. These numbers are worse than some of the other numbers you will see. I believe that the government fiscal spending multiplier is greater than one because we are still deleveraging. The shutdown can re-kindle a psychology of deleveraging that amplifies lost government output. That is bullish for government bonds because it means rates will remain lower for longer.
On the other hand, the spectre of default increases volatility for US bonds, particularly near-dated paper. And we have already seen the markets tacking on this risk premium. That’s bond bearish but only in a limited way and on specific maturities. If we have an actual default, I would expect a flight to safety to reduce bond yields. Government debt is still the safe haven asset class. This will amplify the difference in yields between different debt maturities. And that opens up the potential for arbitrage opportunities in government bonds and their derivative markets.
Equities: As yields fall, we should expect market multiples to rise as discount rates will be lower. Future cash flows will be more valuable, something particularly important for equities. However, I expect this favourable outcome to be relevant for a very short shutdown, 5-10 days at the most. Beyond this, all of the negative externalities come to the fore. And the market psychology moves into multiple contraction mode due to expected future earnings fall. The hallmark of a bull market is multiple expansion, And this expansion comes from an increase in risk appetite, an extrapolation of present conditions into the future, and a decline in discount yields. A prolonged shutdown risks a bear market because future expected earnings fall and multiples will contract. Risk appetite declines and worsening present conditions are extrapolated. So, overall the shutdown will have a negative impact on equities if it continues.
Corporate bonds: Yields have remained low. So asset managers are reaching for yield. That has been bullish for corporate bonds, particularly high yield. However, high yield and convertible bonds are two hybrid asset classes with a lot of overlap with equities. We should expect that a longer shutdown causes high yield to switch (violently) from their abnormal positive correlation with Treasurys to a negative one. High yield will then have a positive correlation with equities. All around, a longer shutdown – and a larger fiscal multiplier – implies serious negative implications. It also implies a violent reversion to the mean for corporate profit margins. That’s negative for high yield and convertible bonds. The flight to quality will also cause a wholesale shift out of risk assets into safe assets. Only a very few corporations in the US are AAA-rated. And that means corporate bonds will suffer.
Currencies: We have already seen the dollar weaken against a basket of currencies, particularly the euro. I would expect this trend to continue with the shutdown. Of particular importance regarding private portfolio preferences for safe assets is the lack of non-government sector AAA-rated paper in the US. The dearth of safe assets combined with the threat of federal government default could be particularly pernicious for the US dollar. It would cause a wholesale rush into safe assets in other currencies.
Gold: The shutdown is a fundamentally deflationary economic event. There is no reason to believe that gold will benefit from this event. I would be a seller of precious metals here.
Commodities: As with gold and precious metals, commodities have no upside in a fundamentally economically deflationary environment. However, we should expect industrial commodities to underperform relative to agricultural commodities, Capital expenditure will take it on the chin as the impact of the shutdown expands.
Of all of these asset classes, what we should be looking for is volatility. The key is areas where the market reaction is violent. We should seek areas where we might be able to take advantage via a hedge or an outsized bet. I believe that the lack of safe assets in the US represents a critical factor in how private portfolio preferences might shift if the market mood turns to risk off. Currencies, equities and high yield are areas where I would expect the biggest volatility.
*Note that nowhere have I mentioned QE. And that’s because I believe QE will have no impact. These other forces are more fundamental. QE works mainly through private portfolio preference and expectations. And they have only derivative impact.