Money & Finance - The Sequester

We are truly seeing a vast dichotomy between the media and the markets. With the sequester coming into effect, there have been multiple reports of gloom and doom on how our economy is going to melt-down trying to digest $85 billion in across the board spending cuts in Washington. Flights will be delayed; there will be massive layoffs amongst our first responders and teachers and our fragile economy will contract back into recession. Hell, Maxine Waters of California estimated some 170 million job layoffs if the sequester were to happen. Never mind that there are approximately 140 million people employed in the United States.

That said the U.S. equity markets are in striking distance of their 2007 highs. Why are we seeing this disconnect between the two messages? Do stock market participants not get it? Or is this an overreaction fueled by a hyper-active politically biased media outlet?

Time will prove the greater fool. What can be said is the uncertainty surrounding the sequester has most guessing what the outcome will be.

“House Speaker John Boehner suggested on "Meet the Press" Sunday a theme of uncertainty surrounding the forced spending cuts known as the sequester, which began kicking in on Friday.

"Listen," he told NBC’s David Gregory. "I don't know whether it's going to hurt the economy or not. I don't think anyone quite understands how the sequester is really going to work."

And he also suggested that he's not sure where the debate goes from here.

"I don't think anyone quite understands how it gets resolved," he said.”

http://www.businessinsider.com/sequester-sequestration-cuts-boehner-obama-meet-the-press-2013-3

The truth about the sequester

One needs to consider the actual risks that we face. During the 2011 debt ceiling debate, Washington decided to raise the ceiling on the condition of appointing a “super-committee” to find much needed cuts in our inflated federal budget. It was then determined that should this super-committee fail, then broad across-the-board cuts would be implemented. The super-committee failed, hence the genesis of the sequester that we face today. Some $85 billion ripped from the federal budget. This is my simplified version of the events, but accurate enough to make some interesting comparisons to what is actually behind this sequester.

“Nearly every news report describes the horrendous $85 Billion across-the-board cuts. The legacy media outlets are wrong on two accounts.

Nick Gillespie in a Reason article documented the actual spending cuts based on the February CBO report:

The first thing to note is that the $85 billion figure that gets bandied about overstates this year's cuts due to sequestration by about $40 billion. According to the Congressional Budget Office (CBO) in its February 2013 report on the budget outlook, "Discretionary outlays will drop by $35 billion and mandatory spending will be reduced by $9 billion this year as a direct result of those procedures [sequestration]...

The CBO total is a cut in spending of $44 billion this year. Half the $44 billion cut is applied to non--defense spending with defense spending absorbing the remaining $22 billion. At 18% of on-budget spending, defense takes the largest hit.”

“Total spending for 2012 was $3,563 billion, and does not include Social Security and other off-budget entitlement spending. Cutting spending across the board would be a bit over a 1% reduction.

But the sequester isn't across the board. Half of the cuts come from Defense. When $22 billion is cut from the smaller defense spending, the cut is 3.3% of defense spending. Non-defense spending is much larger so a cut of $22 billion is a much smaller percentage, 0.76%. Put defense and non-defense cuts side by side following this.”

 

http://www.americanthinker.com/blog/2013/03/how_bad_is_the_sequester.html

http://reason.com/blog/2013/02/19/what-will-sequestration-really-look-like

Minimal Impact

Perhaps market participants are seeing the marginality of these cuts. The Bipartisan Policy Center (via Business Insider) produced this chart based on CBO estimates. A picture is worth 85 billion words.

 

“It shows that there's virtually no change to any of our debt dynamic metrics as a result of these cuts. Yes, the cuts might reduce deficits by a little bit (although they might not, if the economy slows too much) but the trajectory of things is virtually identical.”

http://www.businessinsider.com/the-sequestration-has-begun-and-heres-the-most-pathetic-part-about-it-all-2013-3

Debunking the Myth

There are many political experts that believe political positioning is the ulterior motive behind this end-of-days rhetoric.

From Charles Payne at Townhall.com,“I guess that was the last ditched attempt to force more tax hikes, or as some would call them, more compromise as Congress bolted last night for a three day weekend ahead of all those cancelled airline flights (smart move). I can't believe how much work went into creating real mob scenes over a 2% cut in planned spending hikes that only lessen increases of spending, not actually cut money coming out of the treasury. Of course, now there is a convenient excuse for any hiccups in the economy, and believe me, there will be hiccups.” 

http://finance.townhall.com/columnists/charlespayne/2013/03/02/break-dancing-and-head-spinning-n1523983/page/full/

From John Nolte from Breitbart, “Weeks before the awful-terrible-doomsday 2% cut in the federal budget takes place, we learned that the GDP had collapsed, unemployment increased, and consumer confidence hit a two-year low.

You and I know the economy was on its knees long before sequester. Moreover, Obama knows this. And most importantly, so does the media.

And yet, in his short statement today, Obama told his obedient White house press corps. that if the economy starts to tank, blame a 2% budget cut that represents less than 1% of the overall GDP.

This is all a hustle, a lie, a charade, a long con being manufactured by a desperate president whose economic policies have completely failed.”    

 http://www.breitbart.com/Big-Journalism/2013/03/01/Sequester-Media-Ready-to-Blame-Obamas-Failed-Economy-on-Budget-Cut

From Paul Roderick Gregory at Forbes.com, “I prefer to look at the sequester using common sense instead of arcane Keynesian modeling. If more than a half trillion dollars of stimulus spending created no new jobs between March 2009 and the end of 2010, how can a miniscule cut of $85 billion cost 725,000 jobs over the next nine months, as the CBO wants us to believe? The more sensible prediction is that the sequester will cost us no jobs, despite the President’s stump speech warning about the loss of “hundreds of thousands” of jobs.

Note that that the sequester actually will cut $72 billion from discretionary spending in 2013. Spending on exempted categories actually increases, and total federal spending expands by $15 billion. (And I am sure Congress and the President can find a special emergency as an excuse to spend more, such as the $60 billion on Sandy Relief).”   

http://www.forbes.com/sites/paulroderickgregory/2013/03/01/sequester-costs-750000-jobs-from-those-who-gave-us-the-four-million-job-stimulus/

Crisis Conditioning

Perhaps Cam Hui from Humble Student of the Markets is correct in his assessment that equity investors have just become accustomed to last minute crisis management that has run amok in global politics.

He writes, “So let me get this straight. President Obama is meeting with senior Congressional leaders to discuss sequestration on Friday, after the deadline has passed. Meanwhile, the Dow rallies and defense stocks, which are highly sensitive to government spending, are outperforming the market.

Is the market just conditioned to getting a last minute deal, just like what we saw during the 2011 debt ceiling impasse, or endless eurozone summits over Greece in the same year?

What happens to equity prices if the cavalry doesn't arrive?”

http://humblestudentofthemarkets.blogspot.com/2013/02/the-pavlovian-sequester-response.html?m=1

Bottom Line: We have not bought into the fear mongering throughout our trusted media but we do believe this rally from late last year is running a bit long in the tooth. We do not think the markets will progress much past the 2007 highs and have been slowly taking profits in our portfolio. We are preparing for what we believe is a long overdue correction. Should we be proven wrong and U.S. equities break through to new highs with conviction, we will readdress our investment thesis.

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