A U.S. government shutdown looms large, and it may not end quickly

By Atul Bhatia, CFA

Following the removal of Kevin McCarthy as speaker of the U.S. House of Representatives, we see a high probability of a partial government shutdown in mid-November. Critically – and quite different than our thinking around the shutdown risk in late September – we think this closure could extend for significantly longer than a symbolic 24-to-48-hour period.

Getting the job is hard; keeping it may be harder

The House speaker is a highly partisan role, and candidates typically rely on votes from their own party to be elected. If that precedent holds – and we believe it probably will – the election process looks complicated, since a candidate can only afford to lose a handful of Republican votes and still command the needed majority. The current House Republican nominee – Steve Scalise – has so far failed to command enough support to take office.

In addition to complicating entering office, the thin majority also makes it difficult for a candidate to remain in office. Current rules allow any single member to call for a motion to vacate, the procedural manoeuvre that was used to remove McCarthy. This leaves the incumbency of any speaker in the hands of any group of roughly 10 House Republicans, including the group that just deposed the last speaker.

Any speaker candidate knows this, and is therefore likely to be comfortable pushing an aggressively partisan policy platform. One result is that we think any pre-shutdown budget proposal from the new speaker is likely dead on arrival in the Senate and would never be signed by U.S. President Joe Biden. The odds of a pre-shutdown deal seem very low in our reading of the situation.

Will the lights stay off for a long time?

Under McCarthy, our view was that any shutdown was likely to be symbolic before a pragmatic deal was reached. We see greater risk of an extended shutdown under his successor for three reasons:

• Likely profile of next speaker: As mentioned, candidates for speaker are likely to self-select for more partisan views and are less likely to compromise. The speaker has broad control over the House’s agenda, and can – at a minimum – put up significant roadblocks to any compromise budget deal getting a vote. There are procedural workarounds to the speaker’s gatekeeping, but they are time-consuming and require bipartisan support.
• Voter response may be positive: Polling ahead of the McCarthy budget deal showed that Democrats were receiving significant blame from voters for a potential shutdown, and that closing the government – even if it led to no policy changes – could be advantageous for Republicans. If that polling remains consistent, then we think there’s very little incentive for the next speaker to make concessions in order to support a quick reopening.
• Major policy wins within reach: In the lead-up to passing the September continuing resolution – the stopgap funding mechanism currently keeping the government open – Democrats agreed to pull funding for Ukraine aid, a key Republican demand. The stated reason for the concession was the political impact of prioritizing that single line item at the cost of closing the government. We believe it will be relatively easy for Republicans to secure other victories by using the same messaging: forcing Democrats to either concede on policy points or defend the choice to close the government rather than just give up a particular budget item.

In short, we think the next speaker is likely to want a shutdown, and may be able to gain both a policy and a political advantage from following through with one. Unless polling changes dramatically around which party is blamed for a closure, it is hard to see why a shutdown would end quickly.

The middle way is the hard way

While it’s theoretically possible that a more pragmatic, deal-focused speaker could emerge, it’s hard for us to see how that result is politically viable.

A pragmatist has little to no chance of being elected using only Republican votes, in our view. As recent events demonstrate, deal-making and compromise are inconsistent with the current incarnation of the motion to vacate, and any move to amend that procedure would likely cost a candidate more votes than the slim Republican margin.

In effect, a deal-making speaker would likely need some measure of Democratic support to be seated.

We see this as unlikely for two reasons.

First, the Democrats would likely receive nothing for their support. Any commitment from a speaker candidate would be unenforceable; once seated, the candidate could renege and veer right and Democrats would be powerless.

Second, any commitment would likely be self-defeating. A speaker candidate that relies on Democrat support to be elected would, we believe, be tainted in the eyes of the average Republican voter. The result is that a Republican House member voting for such a candidate is risking their seat, most likely to a challenger from within their party.

One path for this type of solution would be a relatively senior Republican House member who would be willing to act as a caretaker, knowing that he or she could lose their seat in the next primary. In theory, this could work, with bipartisan pragmatic support. In practice, it’s likely a pipe dream.

There are wild card outcomes. The House can elect anyone to be speaker; there is no requirement it be a sitting member. We would not entirely rule that out, but we think it is a fairly remote possibility at this point.

Shutdown impacts and preparation

Shutdowns have historically not caused significant immediate market impacts, as the table on the following page indicates, but it is difficult to draw robust conclusions given the paucity of data on shutdowns lasting more than 48 hours.

Impact of past government shutdowns on markets has been mixed*

This time around, we believe even a brief shutdown is likely to lead to Moody’s cutting the U.S. credit rating below AAA. We see limited direct impact from another ratings downgrade, although a shutdown and ratings move could add to governability concerns, potentially putting pressure on longer-term U.S. Treasury bonds.

Economically, a shutdown that led to a smaller budget deficit would likely prove disinflationary, which could prompt a faster shift to less restrictive policy from the U.S. Federal Reserve. We think bond investors would likely respond positively to that move and would also welcome any improvement in U.S. debt dynamics. A smaller federal budget would likely be a headwind to near-term growth and increase the odds of a U.S. recession, in our view.

An extended shutdown does cause damage, particularly to families dependent on government wages and payments, as well as to the myriad ancillary businesses and contractors that depend directly or indirectly on the U.S. for revenue. Missed payments are typically made good following a shutdown, so some – but not all – of the missed consumption would likely be recovered. The longer the shutdown lasts, however, the smaller the likely recovery percentage.

In this case, we think volatility is likely to increase in the run-up to a potential November shutdown, and we see elevated risk of a potential equity selloff. In a closure, we would favour high-quality fixed income, particularly in the middle part of the yield curve. Longer-term bonds may benefit from a potential improvement in U.S. fiscal dynamics, but that improvement may be offset by governance concerns.