Chief Global Strategist
As we enter the second week of the government shutdown, markets appear unconcerned. Last week, the S&P500 rose to an all-time record high, 10-year Treasury yields edged down and, while the dollar slipped slightly, measures of volatility across stocks, bonds and currencies all remained subdued.
The shutdown is a negative for the fundamentals underlying stocks, bonds and the dollar. Investors might take some comfort in the notion that, since the shutdown was widely anticipated, the bad news must have been priced in. However, it is pretty hard to argue that financial markets have been pricing in any bad news recently, given the continuing rise in stock market valuations. That being the case, investors need to be increasingly vigilant to ensure that, if the market is, in the words of Alan Greenspan, “irrationally exuberant”, their individual asset allocations are not.
The federal shutdown, which started last Wednesday, poses three broad problems for the economy, namely, the drag from the shutdown itself, the confusion it is causing on the state of the economy and the fact that it has occurred when the economy was likely already entering a soft patch.
The Drag from the Shutdown
According to tracking conducted by the New York Times, the current federal shutdown has furloughed 600,000 workers with a further 700,000 “essential workers” being required to work without pay. It should be noted that federal workers are generally paid on a bi-weekly schedule with the next payday occurring on Friday, October 10th. Because of this, so far, the shutdown should not have had a major impact on disposable income. Moreover, both furloughed and essential workers are guaranteed back pay for the period of the shutdown by the Government Employee Fair Treatment Act of 2019.
That being said, if the shutdown stretches into next week or beyond, most federal workers will be missing a paycheck, which could impose a small drag on consumer spending, particularly in D.C., Maryland and Virginia. In addition, according to a 2017 report published by the Volcker Alliance, in 2015 there were 3.7 million contract and 1.6 million grant employees working for the federal government compared to 2 million official civilian employees (outside of the postal service). Contract employees are not guaranteed back pay after a government shutdown and the disruption to their work, along with delays in awarding new contracts, will presumably impose a further drag on the economy.
The administration has also taken the opportunity of the shutdown to freeze billions of dollars in funding to states and municipalities and climate projects and has threatened to convert many furloughs into layoffs.
In an economy with an annual GDP of $30 trillion and 160 million non-farm workers, these effects are still relatively minor. However, if the shutdown drags on from days to weeks, the impact on the overall economy could become more severe.
A Thickening Fog
A second problem with the shutdown is that it is interrupting the collection of data for and publication of key economic reports such as the September Jobs and CPI releases.
This is happening at a particularly unfortunate time since there are major questions, right now, about how the immigration crackdown is impacting jobs and how tariffs are impacting inflation. In both cases, private sector data and government data published before the shutdown give us some ability to estimate these numbers. However, estimates are not as good as actual data and the longer the shutdown continues, the harder it will be to track the direction of the economy.
Navigating a Soft Patch
The shutdown has also occurred at a time when the economy appeared to be entering a soft patch.
On the jobs front, the last four months have seen average payroll job gains of just 27,000 and, we estimate, based largely on private sector data, that the September jobs report would have shown only a relatively minor bounce-back to a 60,000 gain.
Moreover, the next few months look even more challenging for employment. According to the federal office of personnel management, more than 150,000 federal workers took a buyout offered to them in the spring and roughly 100,000 of these workers formally left federal payrolls as of September 30th, with the rest leaving by the end of the year.
From a demand perspective, economic growth could be 3% or higher for the third quarter. However, in the fourth quarter, tariff increases are likely to push inflation higher, squeezing household incomes, while the extra cash from the OBBBA will generally not show up until 2026. A resumption of student loan repayments and the expiration of electric vehicle credits could also slow consumer spending in the fourth quarter. All of this will be softened, to an extent, by the wealth effect of recent stock market gains and continued corporate spending on AI. Still, it looks possible that real GDP growth could fall below 1% or even turn negative in the fourth quarter.
And then there is the issue of immigration and the labor force. Total immigration arrests between June and August averaged 33,400, up only moderately compared to 24,500 per month in the same period a year earlier. It should be noted that the vast majority of these arrests are now in communities far from the border, in sharp contrast to a year ago.
However, the biggest economic impact of the administration’s immigration policy is not in arrests and deportations but in deterring new immigration. Since February, monthly immigrant encounters with border patrol on the southern border have averaged less than 11,000 compared to 1,78,000 per month in 2024.
The State Department has stopped publishing data on immigration visas issued in foreign embassies. However, before the data lapsed, it showed a year-over-year decline in visas of 16% in April and 20% in May of this year, a trend which has likely continued. There is also evidence of a sharp decline in international student visas and the administration has recently boosted the fees on H1B visas to levels that should lead to a dramatic decline in visas issued through this program.
It may well be that overall net immigration has fallen to close to zero as deportations, both voluntary and involuntary, fully offset both legal and illegal immigration. However, even with net immigration of 20,000 per month, because of the aging of the baby-boom generation, we estimate that the labor force aged 18 to 64 could be falling by 20,000 per month – a number with important consequences for both job growth and the unemployment rate.
On tariffs, the Treasury Department is still issuing the Daily Treasury Statement and, from this, we can estimate that total net tariff revenue for September was approximately $30 billion, roughly the same as in August, but well above the $7 billion monthly numbers seen at the start of the year. Initially, it appears that importing companies have eaten much of the cost of the tariffs rather than pass them on to consumers but this is likely to change in the months ahead, particularly when consumers see a surge in income tax refunds in early 2026 and are thus better able to absorb higher prices.
If we assume 50% of the cost of tariffs are passed on to consumers over the next few months, this should add 0.7% to year-over-year consumption deflator inflation – if we assume 100%, then tariffs would add 1.4% to year-over-year inflation. However, it is still an open question as to what this percentage will eventually turn out to be or how much higher tariff inflation could be offset by lower inflation in other areas.
Investment Implications
While these questions are important to economists and investors, they are also important to the Federal Reserve. In the absence of government data on the labor market and on inflation, the Fed may be more willing to err on the side of being too easy rather than too tight as the latter path would undoubtedly ignite a further bout of anger from the administration. Not surprisingly, futures markets are now pricing in an 84% probability of two more 25 basis point rate cuts this year compared to a 64% probability a week ago.
Lower interest rates are generally a positive for U.S. equities. However, lower interest rates brought on by political disfunction and the prospect of slower economic growth, rather than lower inflation, should be less so.
The government shutdown could, of course, be ended by either side in short order, but it will likely continue until the partisans on one side or another perceive that a continuation of the shutdown will hurt them politically. Until this happens, however, investors should recognize the wisdom in continuing to add diversification and reduce risk in portfolios as a government shutdown adds both uncertainty and drag to an economy that was already slowing.