Fiscal brinkmanship has Wall Street on edge, but history says stocks can survive fiscal crises caused by political gridlock.
NEW YORK — How vulnerable is your stock portfolio if the fiscal brinkmanship in Washington spins out of control?
It's tough to quantify the downside risk with precision, given the unknown outcome of the current congressional budget fight. Investors don't know if lawmakers will agree to fund the government beyond Sept. 30, Monday, and avoid a shutdown.
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It's also unclear if Congress will raise the debt ceiling in mid-October before the U.S. runs out of cash to pay its bills — a deal needed to avoid the nation's first-ever default.
But history can serve as a guide. A look back at how the stock market reacted to past budget-related brawls in Congress provides a useful template, or road map, as to how trading might play out this time, and how much financial pain investors might endure.
Investor nervousness is on the rise, witnessed by the price action of the Dow Jones industrial average, which is trading down Friday and is on track for its sixth losing session in the past seven trading days.
Wall Street cites three prior episodes of fiscal brinkmanship dating back to 1995 that offer a glimpse into the way the market prices in this type of political risk.
First, let's quickly outline the risks of the current fiscal saber rattling. The base case, or the Wall Street consensus, is that Congress avoids a government shutdown and a default.
But if a shutdown occurs, it's not likely to cause much long-term damage to the economy or stocks unless it drags on for weeks or more, which is unlikely. Each week the government is shut down, quarterly economic growth will be reduced by just 0.1 percentage points, according to Michael Gapen and Michael Gavin of Barclays.
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Not raising the debt ceiling, however, would likely be "far more destabilizing," they say. It would require an immediate cut in government spending equal to more than 4% of GDP, or comparable in size to the "fiscal cliff" hit. But spending cuts would not rule out a default. In this more bearish scenario, a recession is possible, as are "significant disruptions" in markets.
How have stocks reacted in prior scenarios?
• 1995-96 government shutdown. The Standard & Poor's 500 fell 3.7% during the government shutdown period that ran from mid-December 1995 to early January 1996, according to S&P Capital IQ. The good news is stocks quickly rebounded after the government got back to work, rising 10.5% in the subsequent month.
• Debt ceiling fight in summer 2011. Stocks took a big hit despite Congress' last-minute deal announced by President Obama on July 31. The damage from political dysfunction was already done. From the time Moody's Investors Service, a credit-rating agency, put the USA's triple-A rating on "negative watch" on July 13, to the actual downgrade from Standard & Poor's on Aug. 5 and through the Aug. 10 low, the Dow tumbled 1,700 points, or nearly 14%. The Dow didn't make back those losses until five months later.
• 'Fiscal cliff' fears December 2012. After Obama won a second term, Wall Street shifted its focus to the automatic government cuts and tax hikes, dubbed the "fiscal cliff," that were looming at year's end 2012. From the Dec. 18 high to the Dec. 28 low, the Dow fell more than 400 points, or 3.1%. But after Congress averted the cliff and softened the fiscal blow with a Jan. 1, 2013, deal, the Dow soared more than 300 points on the first trading day of 2013, wiping out all its losses.
If a shutdown occurs, Gapen says stocks will likely suffer just a "temporary setback," as they did in 1995-96 and the recent fiscal-cliff fight. However, a default and adverse credit event for the U.S. could be "immeasurably more disruptive," more akin to 2011's debt-ceiling fight, he warns.