After a pair of stopgap funding measures, Washington is getting ready to play hardball on the government budget. Both sides have drawn clear lines in the sand, and April 8 looms as the day when government buildings could be officially locked, government employees told to stay home and all non-essential services could grind to a halt. Whether the shutdown lasts a few days or a few weeks, your portfolio will feel the impact. And you need to start preparing now…
 
Too many uncertainties
Investors crave certainty. Yet this is an especially murky time. Key questions need to be asked. Will Japan’s economy go into recession as its government tackles the economic effect of the current crisis? How will the Middle East play out (and what will happen to oil prices)? Will more European economies need a bailout? How will the U.S. markets handle the end of the Federal Reserve’s second round of quantitative easing (QE2)? [I also wrote earlier about how investors’ record levels of borrowing on margin could bring the market crashing down…]

The market has climbed a “wall of worry” in recent quarters, but the wall keeps getting higher. A government shutdown, though, is the most tangible of any of these threats and you need to assume a worst-case scenario — simply because that’s what the large herd of investors do in times of uncertainty.

What it means
The timing of a shutdown could not be worse — from an investor’s perspective — as it is scheduled to start just a few days before first-quarter earnings season begins. You can expect any company that derives a significant chunk of revenue from Uncle Sam to take a cautious view, anticipating that a prolonged shutdown would keep them from coming even close to second-quarter forecasts.

In the defense sector, this includes names like Northrop Grumman (NYSE: NOC) and General Dynamics (NYSE: GD). Major projects such as shipbuilding have already been slowed by the temporary funding measures, and these defense contractors have warned that any more stoppages would lead to missed deadlines and, eventually, cost over-runs.

In the technology sector, companies such as Computer Sciences (NYSE: CSC), Hewlett-Packard (NYSE: HPQ) and Cisco Systems (Nasdaq: CSCO) have always relied on the government for anywhere between 5% to 30% of revenue. Even the auto makers rely on the government for a decent portion of their fleet sales.

There are many small and mid-cap firms that have grown nicely in the past decade on the heels of an increasing amount of outsourced government work. The list is far too long to mention, but this is a good time to go over all of your holdings to see how much of their business is derived from government contracts.

This time is different
As the April 8 deadline looms, you may see reports in the financial press that former Republican House Speaker Newt Gingrich’s late 1995 showdown with then-President Bill Clinton, which led to two work stoppages, barely nicked the market. That’s because Gingrich was generally seen to be playing a weak hand and could not hold out for long. Indeed those two stoppages lasted only one and three weeks, respectively, and the GOP eventually blinked. That was partially due to the fact that the U.S. budget gap was already shrinking and headed for surpluses on its own within a few years.

Yet the current crisis is far more significant, and major changes are likely to occur to achieve an outcome. On one side, there is a push to make major spending cuts that would yield a smaller government. Deficits are indeed odious, but they have been a stimulating force for the economy as the government puts more money into the economy than it takes out.
 
On the other side is the view that taxes will need to be raised as part of any long-term budget fix. Here again, the recent era of tax cuts has been a real plus for the stock market, as they have put more money into the hands of businesses and consumers. So no matter the outcome — less spending, higher taxes, or both — this has to be seen as a near-term negative for the economy and the market (even though it is essential that we close the budget gap).

This is not about balancing a budget; it’s about eventually paying down massive debt. The only way to do that is to run budget surpluses, as happened in the late 1990s. That era of surpluses helped fuel a robust economic expansion (and an eventual market bubble) as interest rates came tumbling down. Yet the size of the deficit is now so much larger, rates are already at historic lows and the remedies will be so much more severe that a happy repeat of the late 1990s is no sure thing.

Action to Take –> OK, off with the Chicken Little hat. The sky is not falling. The U.S. economy has proven remarkably resilient to past crises, and in a few months, the possible government work stoppage could be a distant memory. But the next few weeks promise to bring plenty of stomach churning as consumers and companies alike watch the government possibly grind to a halt. That mood would hardly be a positive backdrop for stocks.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…