Market Notes

March 1, 2013
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Now upon the D.C. stage: The sequester
By: Clayton M. Albright III, Director of Asset Allocation
Wilmington Trust Investment Advisors

Key points

Whether you consider it a national embarrassment, a bit of necessary fiscal discipline, a symbol of governmental dysfunction, or all three combined, the federal spending sequester officially arrives today. Under sequestration, automatic spending cuts will reduce discretionary U.S. government spending authority by about $85 billion over the remainder of fiscal 2013 (see Figure 1) and total spending by about $1.2 trillion over nine years. The cuts were conceived as an incentive to spur lawmakers to come up with better ideas for taming the federal budget and passed into law in the heat of the 2011 debt ceiling debate. With 50% of the cuts coming from defense, the thought was that sequestration would be so objectionable that Congress and the president would do everything possible to avoid its implementation. A "super committee" created to address budget issues after the debt ceiling was raised in 2011 was charged with finding enough savings so these automatic cuts would not be triggered, but that effort fell short, leading to this day. Despite all the headlines that U.S. fiscal policy has generated, investors have not appeared worried. Yesterday the Dow Jones Industrial Average finished just below its all-time high, having erased almost all the damage done since the start of the financial crisis.

We believe investors have shrugged their shoulders at the pending spending cuts for a number of reasons. First, the overall magnitude of sequestration is relatively small. Spending reductions made this year would shave about 0.5% from economic growth. Over the next nine years, the $133 billion average annual reduction would represent about 3.7% of total current federal spending of about $3.6 trillion. We do not see how these pending cuts could throw the economy into another recession. Most Americans think government administrators could easily find enough fluff to make cuts at these levels. As shown in Figure 2, recent USA Today / Pew Research Center polls point to overwhelming support for spending cuts to curb the deficit.

There is also this important point: The cuts may never materialize; Congress and the White House could pass a new law repealing the law that set the sequester in motion. One reason to believe that spending actually will be reduced is that the debt rating agencies are watching and have made clear that the U.S. debt rating would be jeopardized by inaction on the deficit. A more likely outcome than the cancelation of the cuts may be changes in the programs subject to them. Another important note: Sequestration does not touch entitlement spending— Medicare, Medicaid, Social Security. Like many informed observers, we believe entitlement reform is key to sustainable U.S. fiscal policies.

Assuming spending cuts do materialize, furlough notices and dismissal notices for contractors could appear this spring and summer. Other impacts may take longer to appear, and there likely will be unexpected consequences. The negative aspect of many of the cuts is the indiscriminate way they may be applied. The sequester actually applies to budget authority, meaning that unspent money authorized from prior budgets could be used to cushion the blow. The rules are also being applied in the middle of the fiscal year, a complicating factor. Cuts must be uniformly distributed at the "program, project, activity" level, which can cause further distortions.

Bank of America reported that spending to overhaul the carrier USS Abraham Lincoln would be cut by 72%, but spending on the M-1 Abrams tank would be increased by 442%.

Not all investors have been ignoring the pending cuts. For instance, defense-related companies such as Lockheed Martin and Raytheon have posted negative returns this year, in contrast to most of the major equity markets, which returned 6–7% for the first two months of the year. These represent isolated and focused ways that investors have penalized those most directly in the path of the sequestration process. Combined with the tax increases put into place back in January, the U.S. economy is facing headwinds from fiscal austerity of nearly 1.5%, but the negative impacts are not likely to overwhelm. We still forecast real (inflation-adjusted) growth of about 2% this year, as we believe housing and rekindled business spending on plants, property, and equipment will provide significant offsets. Corporate earnings are expected to grow this year and in 2014.

Amid the economic recovery and with central bankers around the globe still acting to suppress interest rates, we are not concerned about these relatively modest budget cuts and remain comfortable with our current, slightly aggressive asset allocation policies for diversified portfolios. Our stock allocations are in line with those of our benchmarks, but our bond allocations are aggressively positioned. We continue to favor "non-core" bonds, such as dollar-denominated emerging market debt and speculative-grade floating-rate notes, which we expect to provide some protection against rising interest rates.

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