US government shutdown unlikely to materially impact markets

As expected, the US government is shut down and, true to history, the markets have largely shrugged it off. This marks the 22nd shutdown since 1976. During more than half of the previous 21 shutdowns, US stocks posted gains.¹ While betting markets suggest this impasse could last a few weeks, we believe the economic impact should be limited. Non-essential government spending is a relatively small portion of US gross domestic product (GDP), and while the temporary loss of income for federal workers could dampen demand, backpay typically mitigates the longer-term effects. A more meaningful drag could emerge if the shutdown leads to permanent workforce reductions or deeper spending cuts, which have been threatened by the administration.

Elsewhere in the world, there’s growing evidence that governments will spend more than they have in previous years. This lends further support to a more inflationary environment but indicates a positive environment for stocks, in our view.

Labor weakness in the US

The government shutdown means that the nonfarm payroll data, due to be released last Friday, was delayed. That removes, for a time, a key piece of data that the Federal Reserve (Fed) will be relying on to help guide its October decision. Other sources of labor data, however, are available from private sources. Data from ADP and Challenger last week suggested the labor market across the US took a further step down in hiring.²

The coming month is likely to see more federal workers enter the unemployment statistics for two reasons. First, the end of September marked the final day for workers who had volunteered for deferred resignation, the program in which federal workers were paid to leave their roles. Second, President Trump has proposed further layoffs and cuts in response to the government shutdown.

Given all of this, it was a little surprising to us that the US dollar ended the week largely flat.³ More intuitively, US Treasuries rallied (yields fell),⁴ reflecting concerns about weaker growth rather than credit risk. It’s a reminder that Treasuries trade on macro conditions, unlike corporate bonds. Manufacturing data continues to point to a soft patch, but signs of reacceleration are emerging, even as labor demand remains subdued.

Japanese markets rose

BOJ Governor Kazuo Ueda delivered a somewhat dovish message last week, which helped Japanese stock markets make further gains. The MSCI Japan Index gained more than a third since its low on April 7.⁵ The BOJ remains the only major central bank in a hiking cycle, but it increasingly looks as if the hikes will be a little slower than many had expected. The Japanese yen weakened a little against the US dollar last week.

Over the weekend, Japan’s Liberal Democratic Party (LDP) chose Sanae Takaichi as its new leader, which came as somewhat of a surprise. At the start of last week, Polymarket pointed to a roughly 23% probability of her winning the election.⁶ She’s the fifth leader in as many years, and Japan’s first female prime minister. Regardless of who won, the outcome was always expected to lead to more fiscal spending, which should, at the margin, help support further gains in Japanese stocks. Takaichi is expected to engage in fiscally expansionary policies and embrace some Abenomics policies. (Abenomics is the nickname for the economic policies set in 2012 when Prime Minister Shinzo Abe was elected for a second time. It involved increasing the nation's money supply, boosting government spending, and enacting reforms to make the Japanese economy more competitive.)

This comes against the backdrop of the BOJ reducing its holdings of Japanese exchange-traded funds (ETFs) at a glacial pace. It’ll take more than a century to reduce those holdings. More than offsetting that is the strong demand from domestic investors who have, for many years, kept a large amount of cash. They’re now deploying it into stocks.⁷

European markets hit new highs

Several European markets made new highs last week with strong gains in France and Germany.⁸ These gains may be partly explained by increased confidence that policymakers will follow through on Germany’s fiscal plans. Germany approved a budget that will unleash more than 1 trillion euros of spending. Some of that money will go towards consumption instead of an investment in defense and infrastructure, which had been planned earlier this year. But the scale of the spending is greater than that spent during reunification and the Marshall Plan, as measured by a proportion of GDP. We expect this spending to have a significantly positive impact on the European economy. These government expenditures should lead to both greater capital spending by companies and consumer spending over the coming months and years. If that proves correct, that could be a strong support for further gains in European stocks.