Quick Thoughts: Midnight madness

At the last minute—and not proverbially—Congress passed, and US President Joe Biden signed into law, a 45-day continuing resolution, authorizing US federal government spending until mid-November, avoiding a much-anticipated government shutdown.

Markets are apt to breathe a sigh of relief. After all, a prolonged government shutdown could have led to a dip in spending and, worse, might have ultimately snarled key government services in finance, transportation, and a broad array of services.

But the relief is likely to be short-lived. Saturday’s compromise continuing resolution is short term and may presage another round of political wrangling and brinksmanship in six weeks’ time.

In what follows, we offer a few observations for investors about how to think—and not overthink—the impact of midnight politics on their portfolios.

Why compromise is difficult

To begin, it is important to realize that notwithstanding the latest compromise to avoid a shutdown, intransigence in Washington remains its defining characteristic, and will remain so at least until the 2024 elections.

Under the US Constitution, Congress is granted the power to tax and spend, while the executive branch can only agree by signing such legislation or disagree via its veto power. Under the Anti-deficiency Act of 1884, federal government agencies cannot spend money without approval from Congress (appropriations legislation). Insofar as a government shutdown occurs, therefore, it is because Congress is unable or unwilling to authorize spending.¹

Congress is famously divided, with each party controlling a slim majority in each chamber (Republicans in the House, and Democrats in the Senate). In today’s polarized political landscape, bi-partisan outcomes are a rarity and often only arrived at as a last-minute option, as we saw on Saturday evening.

Importantly, as much as investors may welcome bi-partisan outcomes, they can also destabilize internal party politics. Republican Speaker of the House, Kevin McCarthy, may be challenged this week for the speaker’s role by those within his own party who feel an opportunity to advance the party’s agenda was missed by forcing a shutdown.

The key insight is that narrow majorities within each party leave them prone to instability, which shrinks options even further for legislative leadership.

The conclusion is that investors hoping for a prolonged period of Washington political stability, predictability and leadership are likely to be disappointed. The intra- and inter-party divisions to effective governing have been exposed by the wrangling of recent weeks as deeper than ever.

In the past, investors typically welcomed divided government in Washington. Gridlock ensured that little would change. Taking Washington out of the equation meant that Wall Street could fully focus on the fundamentals—growth, inflation, interest rates, and earnings—that drive the lion’s share asset price returns and portfolio performance.

But today’s form of gridlock is not quite so benign, for at least two reasons.

First, short-term spending authorizations (“continuing resolutions”) must be periodically renewed (or eventually replaced by full year appropriations), meaning that concerns will soon return about a potential disruptive shutdown. Given the US experience of government shutdowns since the 1990s (eight episodes in total), this weekend’s last-minute compromise offers little comfort that a shutdown later this year or in 2024 can be avoided.

Second, the emergence of large US federal government deficits since the global financial crisis—and even more so since the global pandemic—requires, at some point, the ability to find durable solutions to reduce deficits and stabilize (never mind reduce!) the stock of government debt relative to gross domestic product. The events of this past week offer scant hope that addressing those long-term challenges is anywhere in sight.

The upshot is that investors have been given only a short-term reprieve from Washington’s challenges. Over the next few weeks, their focus will return to questions about an economic soft-landing, the prospect for slowing inflation, the implications for Federal Reserve policy, and the start of the third-quarter earnings season. But around the time the ghouls dress in costume for Halloween, the ghosts of Washington will re-emerge in the final weeks’ countdown to a potential mid-November government shutdown.

Midnight is the witching hour. Compromise minutes before midnight has brought near-term relief. But fears have only been delayed, not put to rest.

Enjoy the respite while it lasts. It could get scary again.