No freak-out for financial markets over sequestration

No great sell-off on Friday -- or this year -- as investors learn to ignore Capitol Hill; 'not a catastrophe'

Feb 28, 2013 @ 4:02 pm

By Jeff Benjamin

Despite the best efforts of politicians, the financial markets have all but shrugged off the hyped impact of last Friday's sequester deadline, which includes $85 billion in reduced government spending this fiscal year.

Stock indexes hovered around the break-even point for most of the day, with the S&P 500 actually breaking into positive territory in the afternoon. The large cap benchmark is up about 6% since the start of the year -- proof to some that investors and consumers have grown iskeptical of dire forecasts coming out of Washington.

“You have to separate political posturing from real economic impact, and you can't take every word you hear from politicians as fact,” said Andres Garcia-Amaya, a global market strategist at J.P. Morgan Funds.

“The sequester is very much an important event because it will provide some economic head winds,” he said. “But the markets have shrugged it off because everyone knew for more than a year that it was coming, and it has already been factored in.”

The sequester agreement, which is supposed to reduce government spending by $1.2 trillion over 10 years, was established in August 2011 as part of the negotiations to raise the federal government's borrowing limit.

The original idea was that the spending cuts would be so severe that Congress and the White House would be forced to find some compromise before March 1, 2013.

As the deadline drew nearer — just two months after Washington's nerve-wracking fiscal-cliff debate — the financial markets opted to let this one slide by virtually unnoticed.

“At this point, I think investors are completely turned off by the whole process in Washington,” said Joseph Witthohn, vice president of product development at Emerald Asset Management Inc.


“They've had a year and seven months to get this thing done and now, on the last day, the president [was] talking about everything from planes falling out of the sky if sequester is allowed to happen” he said. “First it was Obamacare, now it's Obamascare.”

As analyzed by the Congressional Budget Office, about half the fiscal 2013 spending reductions will be applied to defense spending. Beyond that, the government's discretionary spending between now and the end of September will drop by $35 billion, with another $9 billion in mandatory spending cuts.

For context, consider that government spending represents less than 30% of the $16 trillion U.S. economy, the bulk of which is made up of consumer spending.

Also, the impact of the $85 billion sequester is 29% less than the economic impact of the Jan. 1 expiration of the $120 billion payroll tax cut that affected all working Americans.

If fully enacted, according to the CBO, the sequester could amount to a 0.5% drag on economic growth during this fiscal year.

The majority of the so-called cuts in the sequestration agreement are actually reductions in the pace of future spending increases, which is part of the reason that people outside Washington are sweating less than those inside the Beltway.

“The market has already had a quarter to digest this, so the sequester cuts are seen kind of as a moot point,” said Daniel Toboja, vice president of municipal bond trading at Ziegler Capital Markets.

“There's clearly a lot of fear-mongering going on, but that's for political reasons, not for financial reasons,” he said. “The debt ceiling and a downgrade of U.S. debt was something to be worried about, but this sequester is not the end of the world, and I think you're seeing that in the markets.”


Brian Frank, president and a portfolio manager at Frank Capital Partners LLC, pointed out that one reason the sequester hasn't raised a lot of concern in the markets is that it doesn't even touch the government's two biggest spending challenges: Medicare and Social Security.

“The sequester cuts are a joke,” he said. “It's not great for the economy, but it's certainly not a catastrophe.”

Mr. Frank added that as a value manager, any negative impact on the markets should play right into his hands.

“We've been getting defensive already, just based on valuations with some health care names and essential services,” he said. “If there is any kind of hit to the economy, our portfolio should be OK.”

Although the idea of reduced spending might rattle Washington, the financial markets are content with the idea that slower growth is still growth.

“The market seems to believe that the cuts are not going to be that bad and that the sequester won't push us into a recession,” said Quincy Krosby, a market strategist at Prudential Financial Inc. “The market is forward-looking and right now, all the growth sectors are strongest, which tells you that the market thinks the economy will continue to move forward.”


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