Despite debt ceiling debate, now is not the time to exit markets

Even though the partial shutdown of the federal government is set to give way to a prolonged — and probably nasty — debt-ceiling debate, now is not the time to bail from the markets.

That said, put your seat belt on.

“It's folly to try and Washington-proof your portfolio,” said Doug Cote, chief investment strategist at ING U.S. Investment Management. “This kind of thing can turn on a dime and the market can go up a lot faster than it goes down. So if you sell now, you're just locking in losses.”

With the government shutdown wrapping up its first week, investors have gotten increasingly nervous, primarily because the longer it lasts, the more it looks like a long-term prospect.

Practically speaking, a short-term partial government shutdown won't have a major drag on economic growth, even though it is drawing a lot of attention, which in turn has been driving market volatility.

The real threat at this point is of a gridlocked Washington grinding into another debt-ceiling battle, which some say could trigger a new level of market fears if it looks as though the U.S. is on the brink of default.

Treasury Secretary Jacob Lew has stated that the federal government has only enough credit available to meet the Oct. 17 debt payment of approximately $30 billion. Other analysts have suggested that the October payment date is less significant than a larger November payment deadline.

Either way, the current scenario has created a messy start to the fourth quarter.

“We came into the fourth quarter with a U.S. economy doing OK, and with a better tone coming from the rest of the world, and I thought we were kind of aligning for a global expansion,” said Joel Huffman, a senior portfolio manager at the Private Client Reserve of U.S. Bank Wealth Management.

“If the shutdown continues for several weeks, it will become more noticeable,” he added. “There's enough momentum in the economy that we won't fall completely off the rails, but the longer it goes on, the more impact it will have at the margins.”

Financial advisers, for their part, are taking it all in stride.

“I don't think it has any impact on the markets,” said Paul Schatz, president of Hertitage Capital LLC. “We're not going to default.”

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Mr. Schatz said none of his clients have contacted him with concerns about the shutdown.

Theodore Feig! ht, an adviser at Creative Financial Design, meanwhile, heard from two anxious clients on Thursday.

“I'm telling them all that the average shutdown is about five days and that, historically, the market usually responds with an 18% increase over the next six months,” he said.

While it is nearly impossible to handicap Washington politics, professional investors are finding themselves drawn begrudgingly into the mix.

“A lot of what we do now has so much to do with government because government has a bigger reach than it has had in the past, so it's something you have to pay attention to,” said Brian Frank, president and portfolio manager at Frank Capital Partners.

“Right now, it's still about taking advantage of the situation if people are going to sell based on the shutdown,” he added. “Unless the shutdown lasts for months, it is not going to have a big impact on the economy, but the market should be much more concerned about the debt ceiling issue.”

As the deadline for raising the $16.7 trillion U.S. debt limit draws nearer, the fight over a continuing resolution to fund the government is likely to morph into a larger and more complex grand bargain scenario that could further complicate matters.

In that context, there is talk of default risk.

“A default would be really bad, much worse than the shutdown, but right now I'd say there is only about a 25% chance of a default,” said Uri Landesman, president of Platinum Partners LP.

Mr. Landesman, who was negative on the equity markets even before the shutdown began, said: “In this market, I would be advising people to sell.”

From his perspective, the colliding of the shutdown with the debt-ceiling fight will not produce many winners.

“Once you get into it, Congress' historically low approval rating will go even lower,” he said. “But now they can fight about what they really care about, which is Obamacare.”

In terms of the market's reaction to! it all, ! Mark Travis, manager of the Intrepid Capital Fund (ICMBX), cited a similar market reaction in August 2011 when U.S. debt was downgraded and stocks saw a few single-day drops of up to 5% over the following week.

“We've been through a very benign period this year with very low volatility,” he said. “Right now, you've got equity indexes that are up more than 20%, so it's not inconceivable that some people will decide they're happy with that return, and they want to take some of the profits.”

Another point to ponder from the 2011 battle is that in the months leading up to August, the rating agencies all sounded the alarm of risk of a U.S. credit downgrade.

“Look at the bigger picture right now — you haven't heard a peep from the rating agencies,” Mr. Cote said. “If the rating agencies are not saying anything, then what are you worried about?”