Dysfunction in D.C. Draws an Eye Roll From Wall Street

With Washington on the precipice of its first government shutdown since Derek Jeter’s rookie year, Wall Street is once again rolling its eyes and tentatively taking its foot off the accelerator.

It’s not that the likely shutdown portends disaster for the economy. It’s just that it reinforces how dysfunctional Washington truly is and signals potential drama over the much scarier $16.7 trillion debt ceiling.

“A shut-down of a few days -- or even a couple of weeks -- would have a modest impact on the economy, but a debt ceiling crisis would be disastrous,” Greg Valliere, chief political strategist at Potomac Research Group, wrote in a note to clients Monday morning. “For the markets, a state of exceptional uncertainty will persist for at least another month, possibly until late December.”

There’s also a sense that it’s time to cue Bill Murray as all of this has a feeling of Groundhog Day. Whether it was the last debt ceiling debacle, or the much-hyped fiscal cliff negotiations, Wall Street is used to shaking its head at manufactured crises in Washington.

“Investors found themselves watching another replay of the circus of the great American political parties, in which their posturing and gamesmanship were again on display (strangely none of them won an Emmy Award last week),” Howard Silverblatt, senior index analyst at S&P, wrote in a note over the weekend.

Markets Survived Last Shutdown

The knee-jerk reaction on Wall Street Monday morning was negative, but not disastrous. The Dow Industrials tumbled as much as 171 points, but more recently were off just 90 points. The S&P 500 shed 0.48% and remains only 2.4% away from its all-time high set two weeks ago. That’s hardly panic.

“Unless a sea monster emerges from the Potomac and swallows the Capitol at 12:01AM tonight, I am dubious that these guys see anything but their own pork barrel receipts,” Michael Block, chief strategist at Rhino Trading Partners, wrote in a note to clients.

The moderate reaction makes sense given that Barclays (NYSE:BCS) estimates that for each week of a shutdown, real gross domestic product growth would only be hurt by 0.1 percentage points.

“What worries many clients we talk with is the absence of a clear end-game."

- Greg Valliere of Potomac Research Group

The four-week shutdown between 1995 and 1996 cut U.S. GDP growth by 0.5% percentage points, according to the Congressional Budget Office.

During that battle between President Clinton and former Speaker Newt Gingrich, the S&P 500 lost 3.7% from peak to trough, according to Sam Stovall, chief investment strategist at S&P Capital IQ. A month later, it jumped 10.5%.

Time to Jump In?

Stovall predicted that if the government shuts down this week, the market could suffer a 5% pullback, but “once it gets resolved, boom the market really takes off.”

That’s why market bulls are not exactly worried about the looming shutdown. In fact, they’re gearing up to do some bargain shopping.

“History suggests this turbulence could be a buying opportunity,” Craig Johnson, technical market strategist at Piper Jaffray, advised clients in a note on Monday. “While we believe the odds of a government shutdown are increasing, we suspect this may prove to be a great buying opportunity for stocks.”

Ed Yardeni, president of Yardeni Research, isn’t backing off his year-end target for the S&P 500 of 1665.

“I see a selloff during October setting the stage for a Santa Claus rally back to my yearend target,” he wrote in a note to clients.

Debt Ceiling is the Real Threat

But it’s less clear that stocks will be able to weather a debt ceiling storm. While market veterans sound annoyed about a possible shutdown, they sound legitimately worried about a repeat of the 2011 debt ceiling debacle.

“The GOP leadership cannot control three or four dozen House radicals who wouldn't care if the U.S. defaults on its debt,” said Valliere. “What worries many clients we talk with is the absence of a clear end-game.”

Congress has until October 17 to raise the debt ceiling or risk a scary default on U.S. debt.

Those concerns have jacked up the cost of U.S. credit-default swaps. The cost to insure $10 million of U.S. debt for one year surged to 31,000 euros last week from just 5,000 euros the week before. That’s the highest level since S&P downgraded U.S. debt in 2011.

Valliere predicted uncertainty over fiscal matters could send the yield of the 10-year Treasury below 2.5% -- after flirting with the psychologically-important 3% threshold just weeks ago.

“Bonds will benefit as GDP estimates fall -- but even Treasuries could come under assault as a debt crisis looms in mid-October,” he said.

Dysfunction From D.C. to Damascus

All of this underscores how the financial markets remain tethered to the action in Washington, whether it’s fiscal fights, the rollout of Obamacare, easy money from the Federal Reserve or the politicized search for a successor to Ben Bernanke.

In fact, Bernanke and the Fed opted to continue their quantitative easing policy in part because of concerns about the political problems.

“I still believe the Fed is the main driver of the D.C. policy bus in the eyes of market participants as this now fourth branch of government, for better or for worse, has been the main crutch of asset prices,” Peter Boockvar, chief market analyst at The Lindsey Group, wrote in a note.

To be fair to Washington, it’s not alone in terms of dysfunction.

Political trouble is also swirling around the capitals of eurozone countries like Italy, as well as India, Brazil and virtually all of the Middle East.