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The Sequester – What’s Up With That?

On March 1, 2013, the federal government spending cuts known as the “sequester” went into effect.  While politicians and the nightly news have frequently mentioned the sequester and its ramifications, much of what is said has been distorted, leaving investors with little insight into the actual implications of the sequester.

Q:  What exactly is the sequester and how did this come to pass? 

A:  It began in August 2011.  The federal government had recently hit its borrowing limit and Congress needed to raise the debt ceiling so that the U.S. would not default on its debt.  The Republicans, who controlled the House of Representatives, threatened to vote against raising the debt ceiling unless substantial cuts in government spending were agreed to.  Facing the looming prospect of a default, both parties agreed to cut federal spending by $1.2 trillion over the next ten years.  Since the parties could not agree on what exactly to cut, they appointed a “Super Committee” to determine how the cuts would be allocated.  If the Super Committee could not come to an agreement on Federal spending cuts, the $1.2 trillion would be split evenly between cuts in defense and cuts in domestic programs through a process called sequestration.  Economists estimate that the cuts will amount to $85 billion in 2013.

Q:  What will be the economic impact of the sequester?

A:  Economists estimate that 2013 GDP will take a hit of roughly 0.5% and, while the sequester went into effect on March 1st, most of the cuts are likely to take effect in the second quarter.  However, the impact will be uneven throughout the country, with those states most reliant on federal spending feeling the brunt of the impact.  In particular, federal spending makes up 20% of Virginia’s and 17% of Hawaii’s respective gross state products.  Further problems are created by the indiscriminate nature of the cuts.  The sequestration process makes no distinction between desirable and undesirable cuts, so everything outside of Social Security, Medicaid, and Medicare takes a hit.  This includes defense spending, which will make up a large portion of the cuts, as well as fewer airport personnel and the more superfluous cessation of White House tours.

Q:  What will be the impact of the sequester on the markets?

A:  Uncertainty has been at a high level since the time of the elections and fiscal cliff negotiations late last year.  However, some sort of spending cuts, either the forced sequestration or some political compromise, had been expected by the markets and so the sequestration has largely been priced in.  The sequestration is sure to be a bargaining chip in the upcoming budget debate as well as the President’s impending request to raise the debt ceiling later this summer.  Ultimately, these discussions are likely to have a larger market impact than the sequester itself.

Looking longer term

Since the sequestration is likely to reduce GDP growth on top of the federal government’s already existing drag on GDP growth, we expect the Federal Reserve to remain in easing mode, at least through the first few quarters of the year.  To note, reduced government spending lowered GDP growth by about 1/3 of one percent in 2012, with notable weakness in the fourth quarter.  Economic growth in 2012, led by the private sector, was all the more impressive considering the government’s negative contribution to GDP growth.

Looking longer-term, achieving a sustainable level of government debt will be one of the most important issues affecting the economy and markets.  The fact that this issue is finally being debated is a positive for the economy long-term.  The sequester, albeit imperfect in its application, presents a series of spending cuts designed to be unappealing to both parties, while producing much needed spending cuts.  We will see over the coming months whether the debate will conclude with a compromise of spending cuts more palatable to both parties.  In the meantime, we reiterate our belief in the virtues of a diversified portfolio and prudent asset allocation.