A $1 trillion strategist lays out the looming worst-case scenario of the government shutdown, and how investors should safeguard their money

Brendan McDermid/Reuters

• Stocks have rallied amid the longest government shutdown in history.
• But as the stalemate in Washington drags on, there's building uncertainty about what it means for stocks
• Kristina Hooper, the chief global market strategist at Invesco, which oversees $926 billion in assets, shared with Business Insider what the breaking point could be, and why it's not a far-reaching prospect.

Stock market investors are still largely shrugging off the longest US government shutdown in history.

The partial shutdown entered its 28th day Friday as Democrats and Republicans had still not reached an agreement over President Donald Trump's request for $5.7 billion to construct a wall along the US-Mexico border.

Since the shutdown began on December 22, the S&P 500 has jumped 9%, recovering somewhat from its worst end to a year since the Great Depression. The market's reaction isn't completely out of whack with history: the median return across shutdowns dating back to 1976 is almost 0%, according to LPL Financial.

However, it's only a matter of time before this unprecedented episode starts to hurt.

"Markets will not be able to ignore it if there is a credit-rating downgrade as a result, and I don't think that is out of the realm of possibility," said Kristina Hooper, the chief global market strategist at Invesco, which oversees $926 billion in assets.

Fitch, one of the big-three credit ratings agencies, has warned that the US could lose its AAA rating if the shutdown drags on into March. Such a move would only be the second ever enacted on the world's most trusted issuer of debt.

In 2011, S&P stripped the US of its 70-year-old AAA rating, down to AA+, and accompanied its cut with a "negative outlook." As this downgrade debacle played out, the S&P 500 tanked 18%.

The decision came shortly after the US raised its debt ceiling to permit trillions of dollars in additional government spending. Yet, S&P was not convinced that the budget deal between the administration and Congress was sufficient.

The shutdown is already taking its toll

Several years after that episode and nearly a decade into this economic expansion, investors are on watch for a recession and what it would mean for the stocks they own.

The ongoing shutdown is not helping to allay these fears.

Starting with the immediate human toll, the Labor Department said Thursday that the number of federal employees filing new claims for unemployment insurance nearly doubled to 10,454 in the first week of January.

More broadly speaking, some economists forecast a hit to first-quarter gross domestic product because up to 800,000 federal workers are not getting paid.

This week, the Trump administration said the shutdown would cut 0.13 percentage points from GDP - up from their previous estimate of 0.08 percentage points. Ian Shepherdson, the chief economist at Pantheon Macroeconomics, is more bearish and expects a quarter of negative growth if the shutdown drags on into March.

There are other risks brewing under the surface, according to Tom Stringfellow, the president and CIO of Frost Investment Advisors.

"[If] there's a disaster somewhere because we didn't have full-time government employees, or any of the affiliated agencies, or any of the service companies actively engaged, that's going to turn sentiment, I think, in a heartbeat," Stringfellow said.

Hooper pinpointed a slowdown in air travel as "one of the first canaries in the coal mine" that might impact the economy and earnings. Delta Air Lines CEO Ed Bastian said this week that the company will lose $25 million in revenue in January because of the shutdown.

A more consequential showdown is looming

The shutdown is the first big outcome of a divided and potentially gridlocked government in Washington that will be with us for at least two years.

"What we're seeing now is the tip of the iceberg," Hooper said. "While it's a partial government shutdown, it really speaks to an incredible level of dysfunction in Washington DC."

This shutdown also doesn't bode well for the forthcoming fight over the debt ceiling.

The budget deal Trump signed last year suspended the debt limit until March 1, after which Congress must pass a bill to raise the debt limit.

In fiscal year 2018, the federal deficit rose to $779 billion, its highest since 2012, driven by the Trump tax cuts that Democrats had been critical of. Now that Congress is divided, Democrats could use the debt-ceiling issue to wrangle tax increases from the administration, setting up a prolonged fight.

Remember that it was a debt-ceiling crisis that triggered the last credit downgrade.

Investing recommendations

Despite their reservations about the shutdown, both Hooper and Stringfellow still see room for growth in the US economy.

"I would warn investors from taking a risk-off stance," Hooper said. "I think risk-aware is a more appropriate approach."

To that end, she advised that investors diversify their stock holdings with alternative asset classes including gold and real estate. That's because these assets have a lower correlation to the volatility of stocks.

She added that US investors should selectively find opportunities in emerging-market and Japanese stocks even though it has paid to have a domestic bias during this bull market.

Stringfellow, without getting more specific, advocated for US companies linked to "anything the consumer touches that involves social media and ecommerce."