Don't Underestimate the Threat of Washington Gridlock

The ongoing partial shutdown of the federal government has entered its second week, with few signs of progress toward an agreement. This is particularly unnerving because the U.S. is close to reaching the debt ceiling, meaning that sometime before the end of the month, the government would no longer be able to pay its bills on time.

So far, the shutdown, and the threat of default, have had a minimal impact on the stock market. The S&P 500 has given up some ground over the past two weeks, but is still within striking distance of the all-time high it set last month.


^GSPC Chart

S&P 500 10 Year Price Chart, data by YCharts

To put it bluntly, investors seem to be repeatedly underestimating the threat of political gridlock. Not only did the market underestimate the probability of a shutdown, it continues to underestimate the potential damage that the shutdown could do.

Furthermore, while investors do seem to be taking the threat of default seriously, most of them still seem to assume that a deal to avert this scenario has to happen. It doesn't. The politicians in Washington may step back from the brink, but they could just as easily go tumbling over the edge. (If you don't believe me, check out my colleague Morgan Housel's recent article on the debt-ceiling crisis.) Now is as good a time as any to prepare for what may be coming -- including worst-case scenarios.

Stalemate drags on

President Obama has demanded a spending and debt-ceiling deal with "no strings attached" (Photo: The White House)

In a press conference Tuesday, President Obama offered the possibility of negotiations about the deficit and Obamacare. This could have been seen as an olive branch, but Obama wants the House and Senate to reopen the government, and raise the debt ceiling first. House Speaker John Boehner countered that negotiations needed to happen before a budget resolution or debt-ceiling resolution could be passed.

Speaker of the House John Boehner has insisted on spending cuts in return for raising the debt ceiling (Photo: Speaker Boehner's office)

The predictable result has been deadlock in D.C. Democrats don't want to be seen appeasing what they see as dirty tactics, while Republicans don't want to give up their best leverage and risk having their priorities swept under the rug.

As of Thursday morning, it appears that the two sides may be able to compromise on a short-term increase to the debt ceiling to allow four to six weeks for negotiations on deficit reduction. That's no guarantee that they'll reach a long-term compromise, though. Indeed, any deal seems likely to come only at the last moment, which means that the current climate of uncertainty will likely drag on until nearly Thanksgiving.

Shutdown damage
While most market observers seem to understand that a failure to raise the debt ceiling would be disastrous, there has been a broad tendency to downplay the ongoing shutdown. It is true that the most obvious effect of the shutdown -- the furlough of hundreds of thousands of federal employees -- will have a minimal direct impact on the economy. However, the indirect effects of the shutdown are much more troubling.

For example, the shutdown is throwing up roadblocks in the housing market. It's more difficult for banks to process loans, and they can't repackage them for sale to Fannie Mae and Freddie Mac until the government reopens and the IRS can verify borrower incomes. Moreover, if the shutdown isn't resolved by the end of the month, local housing authorities will start to run out of money. This could force a halt to public housing construction projects, while also causing big headaches for low-income families.

Turmoil in the housing sector could have ripple effects on automakers like Ford and General Motors . Both companies have experienced resurgent profitability due to the strength of the pickup truck market, which has been boosted by the housing recovery. Housing demand is already softening, and a shutdown-driven drop in the housing market could cause many contractors to put off big capital purchases like new trucks.

Airlines are also likely to bear the brunt of a prolonged shutdown. First, it's worth remembering that airlines saw a significant drop-off in demand around the time that the sequester was implemented earlier this year. Businesses that deal with the government are probably cutting back on travel spending. Even those that are not directly affected may try to minimize discretionary travel out of fear about the overall business climate. The closing of U.S. national parks could also impact leisure travel.

Second, many airlines are having trouble taking delivery of new airplanes, because they can't register them with the FAA. If the shutdown continues for a few more weeks, airlines may have to start cutting flights because of aircraft shortages. Furthermore, oil prices have remained stubbornly high, so airlines have not seen any cost benefits from the shutdown and debt-ceiling worries.

The worst part
The worst part of the shutdown is the likely impact on consumer confidence. While investors are minimizing the impact of the shutdown, consumers are clearly worried. In a recent CNN/ORC poll, 18% of respondents called the shutdown a "crisis," and another 49% said it has "caused major problems."

This is particularly troubling as we are just seven weeks from Black Friday, the traditional beginning of the holiday shopping season. Many retailers earn a significant proportion of their overall profit during the holiday season. Moreover, retailers have to order goods well in advance -- if consumers suddenly tighten their purse strings, retailers could be forced to roll out big discounts to move their excess inventory.

That scenario would be bad for most retailers, but it could prove fatal to some. For example, J.C. Penney has been struggling to recover from a series of strategic blunders it made during the last two years. The company recently released a fairly optimistic business update, but one that is predicated on an uptick in sales during the holiday period.

J.C. Penney has been building up inventory in anticipation of a bounce-back quarter, but if consumers are spooked by the ongoing gridlock in Washington, sales could miss expectations, yet again. J.C. Penney has already used billions of dollars of cash in the last year. The company is running out of financing options, and a big Q4 miss could force the company into bankruptcy, putting more than 100,000 employees at risk of losing their jobs.

Foolish bottom line
While I think that every investor should be concerned about the threat of a prolonged government shutdown, that does not mean that you should panic! Panic is almost never a useful reaction for investors. However, it does mean that you should be especially cautious.

For example, if you've put a lot of money to work in the stock market in the last year or two, but may need to take some out within the next couple of years, now might be a good time to start doing that. (To put it another way, I am fairly confident that the S&P 500 will be a good deal higher than it is today 10 years from now, even in a "worst-case scenario." However, it would not be surprising if it is below today's levels in a year or two.)

Alternatively, if you are looking to buy the dips, you should recognize that the market's valuation is fairly high today, by historical standards. If the economy hits a bump in the next few months that reduces corporate earnings, the S&P 500 could pull back a long way just to get to the average historical P/E multiple. So be careful out there!

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The article Don't Underestimate the Threat of Washington Gridlock originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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