what it is
It’s a mandatory package of federal government spending cuts totaling $1.2 trillion (less assumed savings on associated debt interest) in equal installments over nine years beginning in 2013.
50% of the $110 million in spending cuts are to be taken from the military (which, by the way, accounts for a staggering 25% of total government outlays), 50% from everything else. Social Security, veterans benefits, Medicaid and similar “entitlement” programs are exempt from cuts. Medicare is not, but reductions, if any, are limited to 2% per year.
where it came from
Negotiations over raising the debt ceiling in 2011 spawned the sequester. Democrats and Republicans were unable to agree on $1.2 trillion of future budget cuts back then. So the two sides set up a “supercommitee” with a deadline to iron out differences. At the same time, Congress passed the sequester, a kind of legislative doomsday device, that would go into effect if no agreement was reached. The idea was that the sequester was so unpalatable to both sides that they would be forced to reach some better outcome. Of course, they didn’t.
The sequester was supposed to go into effect on January 1st.
Last year’s fiscal cliff talks postponed the start for two months.
This morning President Obama has proposed an as yet unspecified plan for pushing the sequester back further.
stock market effects
In theory–and, in my view, in actual fact–the failure of all sides in Washington to have even the bare bones of a plan to reduce a dangerously large federal deficit means that investors are placing a relatively low PE multiple on the earnings of publicly traded corporations.
The beginning of any fiscal restraint would presumably result in a lower level of near-term results. And companies dependent on government largess would certainly be hurt. But the earnings negative would be offset–and probably more than offset–by Wall Street awarding a higher multiple to those profits. (The market’s reaction would be caused by a combination of relief that Washington was becoming more responsible and that a source of uncertainty had been eliminated.)
Reaction to the upcoming sequester has varied by government body:
–Politico recently reported that the military has been accelerating its spending since the start of the current government fiscal year. The implication is that the generals and admirals are gaming the system–figuring they’d create a situation where mandated cutbacks would use up such a large amount of their remaining budget that Congress wouldn’t dare to let them happen.
–On the other hand, I’ve been noticing that 4Q12 earnings for government-dependent firms (BMC Software comes to mind) are already being depressed as their federal customers are already cutting orders in anticipation of the sequester being triggered.
what to do
The sequester represents only about 15% of the total fiscal cliff. So it’s not the dire depressant to domestic economic activity that the cliff as a whole would have been. And it appears to be turn out that, in true Washington style, the sequester is being pushed farther down the road. Even if the sequester is triggered, a domestic recession isn’t on the cards.
A significant reduction in government spending this year (and beyond) is inevitable, however. What I found telling about 4Q12 results is that Wall Street has reacted very negatively to the company announcements that this was already affecting results.
I think we all have to clearly understand, for all the stocks we hold, how much of their profit comes from government sources. I’d be wary of any that have significant (say, 20% or more) government earnings and that are not already trading at a discount multiple.