Last week I highlighted the investment implications of continued budget uncertainty: higher volatility. We didn’t have to wait long – on Monday, equity market volatility hit a multi-month high.
Unfortunately, high volatility will not be the only side effect of continued dysfunction in Washington. If the current budget battle morphs into a protracted series of short-term arrangements, raising policy uncertainty in the process, the economy will likely suffer as well.
Historically, rising political and policy uncertainty – as measured by the Economic Policy Uncertainty Index (EPUI) – has been associated with lower economic growth. Every 10 point increase in the EPUI index results in a 0.2% drop in real growth. Over the past few months, the EPUI index has surged from 100 to 160. If the index remains at these elevated levels, it suggests that growth will be approximately 1% slower than it otherwise would have been.
So what are the mechanisms through which political uncertainty impacts economic growth? Here are two:
1. Periods of political and policy uncertainty undermine investor confidence and negatively impact consumption. When consumers are worried about government shutdowns and budget battles, confidence tends to drop. In other words, even if consumers have the wherewithal to spend, they are less inclined to spend.
2. Economic growth tends to be slower when political uncertainty is high because business spending drops as well. All else equal, a corporate CFO will be less inclined to invest in new capital equipment or expand hiring when the government is on the brink of a shutdown. In a similar way, uncertainty over tax or regulatory policy is likely to be another drag on investment spending. As a result, business investment tends to drop as uncertainty rises, another factor contributing to lower gross domestic product (GDP).
While a longer-lasting deal is still possible, given the intransigence on both sides, a so-called “Grand Bargain” looks increasingly unlikely. Instead, the best-case scenario currently appears to be a short-term, last-minute deal that helps the country avoid a default, and hopefully, reopen the government. However, such a deal will likely mean we’ll be back to where we are today in a few months and political uncertainty will remain high.
Under this scenario, while the economy is still likely to grow, it will arguably grow somewhat slower than it otherwise would have. Ironically, despite Washington’s role as the epicenter of the crisis, an investment implication of this scenario is that Treasury bonds are likely to do better in the near term as interest rates rise at a slower pace. Finally, economic damage will be minor if this ends next week and there is a longer-term solution. The longer this drags on – either through an extended government shutdown or a short-term increase in the debt ceiling – the more significant the damage.