Investors have been pulling out of stocks largely on fears of a potential slowdown in China's economy. But to understand what's going to hit their portfolios next, they'd be wiser to look closer to home — to Washington, D.C.
Here's why: Over the next two weeks, the odds of a budget-related federal government shutdown are likely to rise, and that it is going to hit the stock market even if a shutdown is averted.
Washington has until Sept. 30, the end of the government's fiscal year, to craft a budget deal — or, more likely, a continuing resolution that buys lawmakers more time to pass a budget. The government probably won't actually shut down. Congressional Republican leaders, recalling the public relations hit they took that last time a government shutdown happened in 2013, will probably figure out a way to avert it. "There is a desire in Washington to avoid confidence-sapping outcomes as the national election cycle gets into full swing," notes Bank of America Merrill Lynch analyst Michael Hanson.
But that desire doesn't extend across the entire Republican caucus — and merely the increase in the odds of a shutdown will be enough to hurt the stock market, say analysts at The Bear Traps Report, a market letter that has made several astute macro calls over the past few years. The last time the government shut down, in October 2013, the S&P 500 lost 5 percent in about three weeks.
If you're complacent about the risk to your stocks from a government shutdown because you think it won't happen — which means you are like most investors right now — then consider the following, says Grant O'Connor of Bear Traps. Greece never actually left the European system. But when the odds of a "Grexit" rose dramatically last June and July, stock markets in Europe and the U.S. stocks got hit hard. Likewise, if we go from a low perceived chance of a U.S. government shutdown now to, say, a 70 percent chance, which is the Bear Traps forecast, that's going to upset the investors and hurt the markets.
Markets hate uncertainty, and it usually brings volatility. Uncertainty about a government shutdown would do just that. "You don't need a government shutdown to happen. Just the threat of it is enough to cause a selloff," says O'Connor.
Lots of issues have been raised in the current budget debate — from overseas corporate tax reform and authorization of the Export-Import Bank to the highway bill. But at the heart of the heightened risk of a government shutdown lies the controversial federal funding for Planned Parenthood.
Following the August release of "sting" videos by the anti-abortion group Center for Medical Progress, which show Planned Parenthood doctors discussing the disposition of fetal tissue, a group of conservative House Republicans vowed to block any government budget bill that includes funding for the group. The White House will almost certainly veto any budget bill omitting Planned Parenthood funding.
The stakes for Republicans are even higher now because they won a majority in the Senate in 2014 for the first time in eight years, and they are loathe to risk it. "This is why the Republican Senate leadership has publicly ruled out any chance of a shutdown or debt default this year," says Hanson.
The problem for many Republicans, though, lies in the House. There, 40 members of the House Freedom Caucus oppose federal Planned Parenthood funding — and they are dug in on the issue. "They will not under any circumstances vote for a budget with Planned Parenthood," says David Metzner of ACG Analytics, a policy analysis group in Washington, D.C. which evaluates the impact of government policy on the economy and the markets.
House members often have more limited room to maneuver on issues since they hail from districts that are ideologically narrow, thanks to gerrymandering. So they're under more pressure to avoid compromise on core issues, at the risk of alienating their base.
"Who wants the ad that shows the Planned Parenthood videos, and says 'So and so Republican voted to fund that?'" asks another Washington-based policy analyst. "You can imagine as a lawmaker what a perilous position you will be in, in many districts, if you do not signal that you tried to fight the good fight."
Keep in mind that more Planned Parenthood videos are waiting in the wings, says ACG Analytics. What if some of the videos are released in the coming weeks to up the ante in the budget debate? In short, Planned Parenthood opponents could crank up the heat, and soon.
All of this creates serious obstacles for Republican Congressional leaders looking to garner enough support for a federal budget bill without having to give away too much to Democrats to get support from the other side of the aisle. "How they get through this we do not know," says Metzner. "This is a very challenging period with lots of headline risk."
Because the emotions behind the policy positions that will trigger the budget dispute this time run so deep, the chances are higher that we will see intense political brinksmanship that raise the odds of a government shutdown.
How to position your portfolio
Here's how traders and investors may want position portfolios for the government shutdown crisis redux, according to Bear Traps.
- If you are a long-term investor and you know you have strong enough nerves to avoid making mistakes when emotions run high during a selloff (not always easy), then do nothing. Repeat: Do nothing. Because this too shall pass.
- Traders should consider going with defensive names like utilities and "steady Eddie" earners that sell consumer staples. These names tend to hold up better during times of crisis. Duke Energy (DUK), Southern (SO), Con Edison (ED), Procter & Gamble (PG), Colgate Palmolive (CL) and Coca-Cola (KO) are some examples.
- Likewise, traders may want to short the dollar. A potential U.S. government shutdown reflects poorly on the U.S., so it can be a negative for the dollar. PowerShares DB US Dollar Bearish Fund (UDN) is one way to go here.
- Gold, commodities, oil and emerging markets often do better as the dollar weakens, so near-term exposure to these groups makes sense for traders, too. Barrick Gold (ABX), Goldcorp (GG), Market Vectors Gold Miners Exchange Traded Fund (GDX), United States Oil (USO), United States Brent Oil (BNO) and Vanguard FTSE Emerging Markets ETF(VWO) are names to consider.
The bottom line: The Planned Parenthood fight could drag out the government funding battle until the last minute. We could see a deal as late as the final hours of the last day possible, Sept. 30, sparking significant sell offs in stocks along the way — as a potential government shut down gets back on the radar screens of more investors.