Sequestration Deadline: What Investors Need to Know

Michael Teague |

President Obama Meets with Congressional LeadershipOn Friday, March 1st, the day that sequestration is supposed to kick in, President Obama will meet with a bipartisan group of congressional leaders, presumably in order to hammer out some sort of last minute deal to avoid the dreaded across-the-board spending cuts, or at least to reconfigure them in a manner that will preclude as much as possible the derailment of the timorous economic recovery that seems to be taking place in the U.S.

Both sides of this debate have been fairly consistent in their framing and messaging, at least in terms of the broad outlines (and, certainly consistent in using the opportunity to do some finger-pointing):

Democrats claim that Republicans will not compromise on closing tax loopholes and curtailing special interest tax breaks in order to achieve the deficit reduction they say they want so badly.  The White House has accompanied this with a particularly loud tragic chorus that has been warning everyone within earshot of the apocalyptic scenario that will occur if $85 billion in across-the-board cuts go into effect.

Republicans claim that Democrats, and especially those currently in the Oval Office, got their tax increase, and so it is high time for them to make good on their end of the bargain and cut spending, or at least propose some legislation to that effect.

Both of these arguments, if taken at face value, are more or less true, but they leave tremendous room for the sort of disingenuous nature that is a matter of course in politics. The underlying reality never changes much, however: both sides of the aisle are trying to wring the greatest possible benefit out of the confrontation, irrespective of their actual feelings regarding sequestration.

What is often lost in all of the discussion though is what is actually at stake if the cuts go in to effect. Some brief historical background: the sequestration mechanism originates in the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act signed into law by President Reagan with bipartisan support in 1985, when the nation’s debt was at a historical high. It stipulated, among other things, the use of automatic spending cuts, “sequesters”, were the deficit ever to exceed a fixed set of targets.

Several such acts aimed at controlling the deficit have been passed in the years since then, the most recent one being the Federal Budget Control Act of 2011, signed into law by President Obama. According to the Congressional Budget Office, one of the provisions of this legislation is to “Establish automatic procedures for reducing spending by $1.2 trillion if legislation originating with the new joint select committee does not achieve such savings.”

How Sequestration Works:

The Bipartisan Policy Center, a D.C.-based think tank whose name explains its purpose rather succinctly, has produced a report that contains an extremely useful breakdown of the mechanics and potential impact of sequestration.

The $1.2 trillion cuts, if indeed they are enacted, would take place between now and 2021.  They are divided into two categories:

1)  Assumed debt-service savings of $216 billion
2)  $984 billion of sequestration, spending cuts, divided across nine years, so about $109 billion a year

The latter part of this is the bit everyone is talking about. The $984 billion of cuts is split 50/50 between defense and non-defense cuts. The former would lower annual discretionary funding for defense by $492 billion. The latter divides its $492 billion of cuts across four categories: annual discretionary funding ($322 billion), a 2 percent cut to the Medicare program ($116 billion), PPACA exchange subsidy ($7 billion), and other mandatory cuts ($41 billion, see below).

Exemptions:

Furthermore, once again according to the BPC, sequestration in its current configuration contains exemptions:

1)  Most mandatory spending programs are exempt from the cuts: Social Security, Medicaid, Food Stamps, Medicare (aside from the 2 percent cut that is directed entirely at payments to providers)
2)  Non-defense discretionary spending is subject to some exemptions, for Pell Grants, Department of Veterans Affairs programs, Transportation programs paid for the by Highway Trust Fund, and Indian and migrant health centers (aside from a mandatory 2 percent cut)

Effects:

Due to all the exemptions in mandatory spending, most of the cuts to non-defense spending will fall on the discretionary budget (about 35 percent of the entire $1.2 trillion figure). National institutes of health, Section 8 rental assistance, air transportation security and traffic control, education for the disadvantaged, special education, scientific research, disaster relief, disease control, food and drug safety, and mental health services would all see a reduction of about 12 percent in their operating budgets in the year 2013.

Across the board cuts also apply to defense, of course. These will be particularly onerous in the sense that the Budget Control Act explicitly requires line-by-line cuts, with little leeway for managers to shift the cuts from more important to less important parts of the military budget. Nearly literally across the board, in other words.

These are the broad outlines of what, and by extension who, would be most affected by sequestration. Jobs, both government and private-sector, will take a hit (according to the BPC, over one million through 2013-2014), and according to the Congressional Budget Office, the 0.1 percent increase recently made in GDP growth could be completely wiped out with a reverse of about 0.6 percent.

Wall Street:

The markets seem to be taking all of this in stride. All major indices traded higher for most of the day before edging lower before the close, largely due to good and/or encouraging economic indicators, particularly the housing market, and this despite the recent payroll tax increase that has hit consumer spending to some extent.

The consensus seems to be that sequestration, in its current across-the-board format, will obviously be bad for the economy, which aligns with what has already been said. James Koutoulas, CEO of Typhon Capital Manager, prefers a balanced approach. In an interview on Friday, he made the point that the problem is not with cuts per-se, but with where the cuts are applied, which “jeopardizes this recovery, which could make deficits even bigger if you increase tax revenues as well”.

This begs the question about why there seems to be bullish trend emerging from this week’s market activity, with indexes not only up but approaching new all-time highs. Are traders and investors just tired of hearing politicians cry wolf, again, the way they did with the fiscal cliff negotiations last month for instance? Or is the relative lack of hysteria on Wall Street just a sign of everyone collectively and stoically holding their breaths and hoping for the best?

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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