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The Specter of the Sequester

Absent a deal from lawmakers, automatic federal spending cuts totaling $1.2 trillion over the next ten years are set to take effect starting this Friday.

 

David Joy

Chief Market Strategist,

Ameriprise Financial

 

 

"The world will not end on Friday. At least not because of the sequester."

Barring a last-minute deal, the automatic federal spending cuts, known as the sequester, will take effect this Friday, March 1. These cuts are designed to reduce discretionary spending across the board, and will fall especially hard on the Department of Defense. Voices decrying this indiscriminate budgetary ax can be heard from a number of quarters. The Obama Administration warns of layoffs to teachers, fire, and police, as well as air traffic and TSA personnel. Governors warn of recession in those states most dependent upon defense spending. Others warn of an unacceptable decline in our nation’s military preparedness.

Background

If so few seem to think the sequester is a good idea, why are we doing it? It all goes back to the deal that was struck in Congress in the summer of 2011, during which the debt ceiling was raised in exchange for these automatic spending cuts as a way of ensuring that the federal budget deficit would be reduced over time and that the rate of growth in the nation’s debt would stabilize and, eventually, decline. The cuts were purposely designed to be so simplistic, and, as a result, so unappealing, that Congress would surely devise a better plan if given enough time. Presumably to increase the odds of a bipartisan deal, a small working group of twelve members of Congress was empaneled to craft a solution. They failed, leaving the sequester to take effect on January 1, 2013. The problem was that the Bush tax cuts were also scheduled to expire on this date, after having been extended for one year. This combination of tax hikes and spending cuts, otherwise known as the fiscal cliff, was widely forecast to push the U.S. economy into recession if allowed to take effect. So, at the start of the new year, Congress agreed on a permanent extension of the Bush tax cuts for most Americans, except for those in higher income brackets. The effective date of the automatic cuts was simultaneously postponed until March 1, presumably, once again, to buy enough time to reach a deal.

Of course, no deal has been made. The two biggest sticking points between the parties seem to be whether entitlement programs should be reformed as part of any deficit deal, and whether sources of additional tax revenue from high-income taxpayers should be identified at the same time. The president and Democrats in Congress are counting on Republicans being pressured into altering their position by polls that show they would overwhelmingly take the blame for the economic consequences of the cuts. Republicans counter that if the sequester is the only way to slow out of control spending, so be it—better that than having the country end up like Greece.

 

© 2013 Ameriprise Financial, Inc. All rights reserved.

 

Impact

The world will not end on Friday. At least not because of the sequester. But, it will be a drag on the economy. In total, the sequester represents $1.2 trillion of spending cuts over the next ten years, with $85 billion of it coming this calendar year. According to the Congressional Budget Office, that would trim roughly 0.6 percent from GDP this year. That’s a big hit for a slow-growth economy already dealing with income and payroll tax increases. But, the budget deficit would fall to 5.3 percent of GDP, its lowest rate in five years and about half the peak in 2009. That would still result in a deficit this fiscal year of $845 billion that must be financed with debt. The CBO estimates overall 2013 GDP growth at just 1.4 percent, and projects unemployment to average 8.0 percent. But it also expects both measures to improve in 2014. If the sequester takes effect and stays in effect, the deficit would fall to a low of 2.4 percent of GDP in 2015, but rise thereafter to 4.0 percent in 2023. Federal debt as a percent of GDP would be generally stable, but still rise to 77 percent of GDP in 2023, and be on a rising trajectory.

The other reason that everything will not grind to a halt this Friday is that the sequester’s primary effect on federal workers will not be felt for roughly thirty days. Many workers must be given thirty days’ notice before unpaid furloughs begin. That also buys additional time for any possible deal to emerge. And some of the work reductions would come through reduced hours rather than layoffs, meaning that government services will continue, but likely at a slower pace.

When will it be resolved?

There are two additional deadlines in the weeks ahead that will undoubtedly impact the budget debate if the sequester remains in effect at the time. The first is March 27. That’s when the federal government runs out of money to operate. Even though the government operates on an October 1-September 30 fiscal year, it has not been operating under a full budget authorization for years. Instead, it has been operating under a series of shorter-term authorizations to run things for a few months at a time. The most recent of those expires on March 27 and a continuing resolution is required to keep the doors open. So, if the sequester is still in place by then, expect another showdown, this time one that could shut down the government. And if we manage to somehow get beyond all that, sometime between mid-May and mid-July, the debt ceiling will need to be raised once again, providing another opportunity for confrontation.

Markets

So far, investors have been apparently quite sanguine about the budget outlook. The S&P 500 fell last week for the first time this year, but it gave back just 0.3 percent after suffering a sharp decline on Wednesday in response to the release of the Fed minutes, not anything ostensibly related to the budget. And the index remains 6.3 percent higher on the year. The yield on the ten-year Treasury note is unchanged from where it began the month of February at 1.98 percent. Nor have credit spreads widened in the past few weeks. That relative complacency might be tested in the days ahead, but concern regarding the sequester seems relatively modest. That may be attributable, in part, to an expectation that Congress will reach a last-minute deal and the sequester will not be triggered. Or, it could be because of the recognition that the size of the cuts ismanageable for the economy, and good for the country’s balance sheet. Whatever the case, any discernible reaction has been quite modest.

What should you do?

Longer-term investors need not necessarily react to the inevitable rise in political rhetoric in the days ahead. No one likes the arbitrary nature of the cuts dictated by the sequester, and there is certainly a better way to be found to reduce the nation’s budget deficit. But that process was going to commence sooner or later, anyway. State and local governments and the private sector have done a good job of deleveraging over the past five years, and now it is the federal government’s turn. In that respect, and in the absence of a more thoughtful plan, the sequester is a welcome development. We have to begin somewhere. And we should not overlook the fact that the private economy has been improving beneath the political headlines. If Washington would just exert some leadership and address the long-term deficit problem in a bipartisan way, the economy would likely accelerate. The CBO’s forecast of improving activity in 2014 is not because they expect any legislative breakthrough, but rather because of underlying economic momentum.

Given Washington’s track record, an acceptable compromise may be too much to ask. Perhaps the best we can hope for is a continuation of the lurching from crisis to crisis that we have lived with for the past few years. We should be used to it by now, anyway. And even with that, the economy has continued to improve and stock prices to rise.

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

It is not possible to invest directly in an index.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC

 

© 2013 Ameriprise Financial, Inc. All rights reserved.

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