The Seriousness of the Sequester

There’s a debate at play in the market this week as to whether the “Sequester” is serious enough of an issue to worry about or if it’s just an overblown political ploy. I for one do not see the Sequester as anywhere near as serious an issue for investors to consider or stocks to discount as the debt ceiling or the fiscal cliff, and I believe the market agrees. Still, there are some specific points about this Sequester issue that are still highly concerning, all of which focus attention on the silly way our politicians are going about our business and still failing at it.

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Sequester

The Sequester is a set of self-inflicted wounds pending implementation on March 1st unless other offsetting action is taken by the government to redirect and control budget cuts. Dreamt up in 2011, the set of sequester cuts have been designed to be so undesirable to both political parties as to lead our politicians to a better compromise. However, even this self-destructive and politically preposterous consequence has so far been unable to get our bifurcated government to budge.

Federal Reserve Bank Chairman Bernanke opposes Sequestration, indicating that it adds an unnecessary burden to a not so hot economy. The impact of Sequestration is estimated by the Budget Office to be 0.6% against Real GDP growth this year. That contributes to a 1.5 percentage point drag to Real GDP caused by spending cuts this year, according to Bernanke’s prepared testimony to Congress this week. Chairman Bernanke adds that a slower recovery would actually lead to less deficit reduction due to its stifling of economic growth. Bernanke suggests replacing Sequestration with policies that reduce spending less dramatically in the near-term, though more substantially over the long-term.

Still, take note that the Sequester does not threaten to drive the economy into recession. We realize that our budget deficit is a serious long-term issue, especially if entitlement programs are not addressed. So bearing some cost now may be beneficial to us later. You might consider it like bearing fever while your body fights off a virus; it’s necessary though painful. And like the debt ceiling issue, controlling the budget should help to support the full faith in credit of the United States and so keep our borrowing rates manageable, but it does so in a very meaningful way. Raising the debt ceiling just sort of passes the buck. Unlike the fiscal cliff, the Sequester does not put as much direct pressure on the economy as a whole, but on sectors of it. Only certain consumers will be burdened instead of all of them or the most in need. Where the fiscal cliff threatened to drive the economy into recession, the sequester cuts (or cuts of some sort to replace them) represent a lesser drag but reflect important medicine.

Stocks have been moving lower off early year highs on fear, with the SPDR S&P 500 (NYSE: SPY), SPDR Dow Jones Industrials (NYSE: DIA) and the PowerShares QQQ (Nasdaq: QQQ) all volatile lately. However, today, as we near the implementation of the $85 billion in spending cuts scheduled for March 1st, the SPY, DIA and QQQ are actually gaining ground. Positive economic data is proving more powerful than the sequester threat.

While it’s unfortunate that the forced spending cuts aren’t leading the government to work together for better solutions, it’s worse that the defense sector gets held hostage for it. After feigns and fake outs too many other times though, the stocks in the sector have not flinched until recently. There’s a sort expectation that things will be worked out as always, but I’m not sure they will be this time. As you can see by the table below there’s no relative underperformance visible in the sector or the specific stocks listed against the performance of the SPY. Still, if the cuts go into effect stocks operating in the specific areas of cuts will likely see impact. Obviously, a heightening likelihood of the confrontation of Iran is working in the group’s favor and helping to support shares nonetheless.

Security	February Through 2/26
SPDR S&P 500 (SPY)	+0.2%
PowerShares AeroSpace & Defense (NYSE: PPA)	+1.1%
General Dynamics (NYSE: GD)	+0.9%
Honeywell (NYSE: HON)	+1.9%
Northrop Grumman (NYSE: NOC)	Unchanged
Rockwell Collins (NYSE: COL)	-0.1%

But what bothers me most about sequestration is the fact that the government had to resort to ploys to force itself into action, and what’s worse is that those ploys have not even worked as yet. All the government has done is shined the spotlight on itself and its weaknesses, and that only serves to further destabilize it and bring radical powers and parties into greater favor, like we are seeing now in Europe. Our representatives had better wake up and lead before they are replaced because of their ineptness, and by their own doing. As we stand today, I am not sure if Washington has done more to help stocks or to hold them up, but I am certain that it could do more for the investment sector.

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