Fear and Loathing in DC: A Savage Journey to the Heart Of the Government Shutdown

One of the things you learn from years of dealing with markets, is that you can’t turn your back on a market participant, but always turn your back on a crisis. Especially when it’s waving a razor-sharp hunting knife in your eye.

In the past few days there have been countdowns, experts have talking about how horrible the outcome will be if we go over the fiscal cli… erm, government shutdown or hit the debt ceiling.

First, let’s just agree that there is quite a big difference between the two issues. The US government shut down is the 12th time since 1981, and it will more than likely cause very little distress.

But if the US hits the debt ceiling and eventually technically defaults, it will be the first time in history in which a country defaults on purpose, and the potential outcome can be absolutely catastrophic on a global scale.

It seems like a pretty unlikely outcome that politicians will let it get that far, and a last minute deal is very likely indeed.

But what about government shutdown?

Markets

First question: What will happen to the markets?

Answer: Probably absolutely nothing, after the less than a percentage drop we saw leading in to it.

Bank of American Merrill Lynch breaks it down nicely in a recent note (emphasis is mine):

Since 1981, we have had 11 government shutdowns, most of which have lasted fewer than three days. The most recent two shutdowns, however, lasted longer (Table 2). And since 1981, average returns for the S&P 500 have been flat to positive in the month preceding a shutdown (+0.1%), during the shutdown (0.0%) and the month following a shutdown (+2.5%).

So there you have it. The shutdowns are exceedingly common and have happened under every president since 1981, except W.

And they even seem to have some positive impacts on markets.

How Will It Go Down

If you are a bit on the sadistic side and do not care that lowly paid government workers will suffer without pay, you might find the power play in Washington rather interesting.

If you have a bearish perspective on life, you might say they are fighting over the seating arrangements on the Titanic, but since I have a more upbeat world view, I’d say they’re on the sister ship of the Titanic, the RMS Olympic.

What’s interesting about the current negotiations is that the GOP might not come off as equally bad as in the previous negotiations.

There’s one reason for this: Obamacare.

Again from the lovely people over at Bank of America Merrill Lynch:

Our economists suggest that the Republicans may be more willing to risk a government shutdown if it were to come under the guise of dismantling the unpopular Obamacare, and recent polls suggest that Republicans would bear less blame for the shutdown than they might have in the past. Meanwhile, reelection risk is less of a concern for Obama. Thus, we estimate that the risk that Washington fails to meet one of the deadlines is now 30%.

How To Invest In Such Chaos

Most profitable trading systems, either for the small retail trader or the big hedge funds, tend to work best in markets that are not affected by large binary events, such as the debt ceilings, wars, market crashes or budget fights.

Albeit that journalists might shine a light on traders who make good or bad bets on such unpredictable events, and while it seems smart to use the events to increase the P&L, it is more often than not a bad idea to trade something so unpredictable.

Using the basic data from BOFAML quoted earlier, one can safely say that the budget fight means nothing for markets. Price action, flow and the great rotation is probably more important than the budget fight.

And the smartest guys in the room expect only a slight disruption. From a recent Goldman note:

A shutdown would have modest macroeconomic effects. We estimate a two-day shutdown would reduce growth in Q4 at an annualized rate by 0.1%p.

“No sympathy for the devil; keep that in mind. Buy the ticket, take the ride…and if it occasionally gets a little heavier than what you had in mind, well…maybe chalk it off to forced conscious expansion: Tune in, freak out, get beaten.”

― Hunter S. Thompson, Fear and Loathing in Las Vegas

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