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7 Sequestration Facts Every Investor Should Know

March 10 2013, Mitch Zacks, Senior Portfolio Manager

Federal sequestration spending cuts are now being implemented. This will affect the market and economy in several ways that investors must be aware of.

Today we will outline 7 important facts that every investor should be aware of in regards to the budget cuts.

1. The Size of the Budget Cuts

The Federal government has agreed to reduce spending by $1.2 trillion over the next nine years, which amounts to $130 billion a year. This is set to start immediately and then ramp up over time. This fiscal year, $85 billion in cuts are required, and then $85 billion the year after. Subsequently, the spending cuts ratchet up in the years following.

Keep in mind, U.S. GDP is $16 trillion, and the budget deficit is 5.3%, or $840 billion. Therefore, spending cuts of $85 billion takes the U.S. deficit to roughly $760 billion. As U.S. government spending decreases, it reduces GDP, reduces corporate earnings, and could have a negative effect on the market over the short-term.

2. Defense Spending Cuts

A pullback in defense spending is the biggest news.

None of these cuts will fall on enlisted military members pay, but they will cause cutbacks to the civilian defense labor force and the ongoing training these individuals receive. Many big budget and high tech defense programs seem to be on the chopping block as well, so the cuts could stretch across the defense industry as a whole.

3. Negative Effect on Defense Industry

The U.S. has the world’s largest aerospace and defense market and the world’s largest military budget. The industry is largely dependent on U.S. government contracts. Defense spending by the government therefore decides the outlook for the industry.

The bottom line is that many defense related companies will be negatively affected by the sequestration, and ultimately the prices of defense industry stocks will tend to fall.
The sequestration will hurt large defense contractors, but smaller companies will fare far worse. Smaller companies are less diversified than many of their large cap counterparts, and these cuts will have a greater effect on their bottom line.

As a result of the sequestration, we think the earnings of small-cap defense industry stocks will be under pressure.

4. Greater for Long-Term GDP Growth

While the sequestration will be a negative for economic growth in the short term, we believe the spending cuts will result in a rise in private growth over the long term.

The U.S. Federal deficit needs to be reduced in order to raise the long-term growth rate potential of the economy. As the U.S. government continues to run a deficit, there is an increasing amount of debt that is issued in the form of treasury bonds.

This debt crowds out investing in the private sector. In the private sector, new ideas, products and companies may not get funded at a lower rate because investors tend to purchase government debt as opposed to lending to corporations. As the debt is reduced, or at least stops growing at such a rapid rate, the economy will benefit over the long term because it will lead to positive growth for the private sector. We believe this is why the market has not reacted negatively to the sequestration. At the end of the day, cutting spending helps long-term GDP growth.

5. Help for the U.S. Credit Rating

Cutting spending helps ensure previous deficit spending won’t ruin the credit rating of the U.S. International bond investors would not be happy if U.S. debt continues to grow astronomically. Reduced spending will help prevent a downgrade of the U.S. credit rating.

We see an improvement in the U.S. credit rating as a positive for the market.

6. Budget Cuts Do Not Tackle The Big Issues

The biggest problem with sequestration is that it does not address entitlement programs. Medicare and Social Security are not being touched. Politically, both sides of the aisle do not want to touch entitlement programs that support the elderly because of the historic consequences on national elections.

7. The Budget Cuts are not likely to cause a Stock Market Reversal

The stock market is soaring to new highs, largely, because of the Fed’s quantitative easing programs. The biggest risk to the market is the reversal of those programs as we believe that would trigger a massive sell-off in the equity market.

Cutting spending actually reduces the risk that quantitative easing will stop. This is because the budget cuts soften the economy, which allows the Fed to continue to essentially print money. Effectively, budget cuts increase unemployment and therefore reduce the chance that the Fed is going to scale back their quantitative easing programs anytime soon.

Cutting spending has become a sideshow. The Fed is the key. The fact that the stock market is approaching new highs is proof that the market and economy are fine with these cuts.

What’s Next

Down the road, we need to see the politicians agree to more spending cuts, and agree to do it rationally. This would help the stock market and the economy. So far, they are not doing it in a coherent, economically efficient, fashion.

We continue to believe over the long-term the market is attractive at these valuation levels.

Source: Zacks

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