Is the US government shutdown going to cause a bear market for stocks?

Zeitgesit: Valuations don't cause bear markets, recessions do. The longer the shutdown goes on the closer we get to the bear.

Back at the start of the US government shutdown investors were pretty sanguine about the prospect as historically these events didn’t tend to have an impact on the stock market. 

But I noted that “deep political divisions could see this drag on. A longer shutdown could have serious consequences for stocks”.

I also noted that “there could be a greater impact on equity markets and bonds markets due to recent economic policy changes and ongoing uncertainty that brings" and that“a long shutdown could sap investor confidence”.

So now that this shutdown is the longest in history, where are we at?

It's been a very rough week on Wall Street, particularly the Nasdaq, down over 4% for its worst week since April. This week’s pullback in technology stocks may have little to do with the shutdown. It seems investors have really started to worry about what JPMorgan's Michael Cembalest called the AI and data centre "blob". There were a couple of those circular deals announced that maybe took it a bit far, and then OpenAI CFO Sarah Fair said the government should backstop AI capex with loan guarantees. Those comments seemed like the type to jangle some nerves on Wall Street. Plus Deutsche Bank is reportedly keen on hedging its AI exposure.

But we should remember that everything in financial markets interrelated. Investor confidence is clearly wobbling – valuations are suddenly a concern, but for what reason? Risk sentiment may be the victim of a prolonged shutdown as much as AI fatigue.

Money markets are showing signs of stress

There are signs of stress in money markets due to the shutdown. Fed balance sheet reduction and a deluge of T-bill issuance has pushed up spreads in money markets, which has been amplified by the shutdown, according to Torsten Slok from Apollo.

Here he is in a note today: 

“The bottom line is that the financial system is nearing the point where reserves are no longer ample. We are watching this development very closely because if rates volatility in funding markets persists, it could begin to have consequences for credit markets.”

If liquidity becomes an issue and we see tightening in financial conditions, it could see this pullback get worse.

Consumer confidence is cratering

The shutdown pushed consumer sentiment to its lowest in more than three years, just above its worst ever level, according to a University of Michigan survey today. Its Index of Consumer Sentiment fell to 50.3 for the month, down 6% from last month. Notably sentiment around the jobs market has cooled markedly with 71% of households expecting unemployment to rise over the coming 12 months, against just 9% seeing it falling. Net 62% expecting job losses to rise is up from 52% a month ago.

UoM’s Joanna Hsu:

“With the federal government shutdown dragging on for over a month, consumers are now expressing worries about potential negative consequences for the economy.”

Economic impact larger than thought

White House economic adviser Kevin Hasset said the economic impact of the shutdown is far worse than expected, citing a slowdown in construction and travel being hit. Today has seen airlines slash flights due to impact of the shutdown on air traffic control.

"Travel and leisure is a place that's really being heavily hit right now, and if it continues to get hit, if the air travel thing goes south for another week or two, then you could say that they would have at least a near-term downturn,” Hasset told Fox.

Jobs market already looking wobbly - from the data we are getting

Challenger reported the highest level of October job cuts in 22 years, citing AI as a reason for the layoffs. Challenger notes that like 2003 a disruptive technology is changing the landscape (back then it was the mobile phone). Year-to-date layoffs are up 44% on last year. 

Closing thought

AI and the shutdown are the problem. The AI blob is a worry. Parts of the market need to pull back further. Job losses are going to get worse if we look at the evidence around AI and the shutdown. On the shutdown, Democrats won big this week in elections across the US, notably in New York. Emboldened by this success they seem set to block a new GOP proposal to end the shutdown. This shutdown could have further to run – with implications for risk sentiment in stock markets as well as for the real impact on the wider economy. Remember that valuations don't cause bear markets - recessions do. Given the AI bubble is being pricked, it could mean we are in the middle of the 10-20% correction that Goldman Sachs CEO David Solomon said earlier this week was on the horizon.