What is the Sequestration and What Will Its Impacts Be?

shutterstock_110566631

The State of the Union aired earlier this week – but what is the real state of our union when it comes to the looming impacts of sequestration?

The budget sequester – originally the brainchild of White House negotiators cobbling together the framework of the Budget Control Act – was supposed to be the whip that forced Congress to get serious about cutting spending. If Congress can’t come up with a more targeted plan, then the Budget Control Act would kick in and force federal agencies to reduce all discretionary spending by about 10 percent across the board.

The savings from this, in theory, would equate to some $1.2 trillion dollars over the next ten years – almost the same as the $1.329 trillion cost of ObamaCare from 2013 through 2023, according to the Congressional Budget Office.  But at what cost?

Impacts of Sequestration

The White House this week distributed a projection of what would happen if Congress doesn’t make a deal acceptable to the President – thereby triggering the automatic spending cut provisions of sequestration.

For example, according to the Obama Administration:

  • “The Federal government would have to cut Small Business Administration loan guarantees by $902 million.
  • 70,000 young children would be kicked off Head Start, 10,000 teacher jobs would be put at risk, and funding for up to 7,200 special education teachers, aides, and staff could be cut.
  • Under a sequester [research and development] progress towards cures would be delayed and several thousand researchers could lose their jobs.  Up to 12,000 scientists and students would also be impacted.”

Economics 101: How Will Budget Sequester Impact the Economy?

Let’s get back to basics.

John Maynard Keynes, the man behind Keynesian economics, posited that government spending is, all other things being equal, stimulatory. When government spends borrowed money, it still sees money changing hands. Government employees get paychecks, and they go out and spend money themselves, with people who themselves spend money, etc.

This much is not seriously in dispute. Spending is stimulatory, and so when the federal government reduces spending, it has a tendency to slow the economy down. We sidestepped the tax part of the fiscal cliff with the New Year tax reform deal. But the sequestration spending cuts are out there and, if they are any good as spending cuts go, they are going to bite.

How much? The Center for Bipartisan Analysis believes that the combined defense and non-defense portions of sequestration will force a reduction of as much as 15 percent on the discretionary portions of federal spending. The resulting de-stimulation, should sequestration come to pass, will cost Americans about a million jobs over the next two years. Not that they project a contraction: The CBA projects 4 million new jobs over the next two years if sequestration doesn’t come to pass, and 3 million new jobs if it does.

Impact on Small Businesses

The outlook for small businesses may be even more dire: A recent projection by Prof. Stephen Fuller of George Mason University, done in conjunction with the Aerospace Industry Association, anticipates that sequestration will put more than 2 million jobs at risk in 2013 alone, should it come to fruition. Almost a million of those job losses will come out of the hides of small businesses – which will have the most difficulty absorbing them. Half a million-job losses, Fuller projects, will come from the defense industry, with the State of Virginia taking the brunt of the impact.

Impact on U.S. Defense Programs

In theory, the impact of sequestration is going to be most pronounced in defense programs. Originally, the sequestration provisions for fiscal year 2013 were supposed to result in an 8 percent cut to defense programs. But because the Budget Relief Act of 2012, passed right after New Years, postponed the spending cut provisions of sequestration by three months, the full first-year effect of the spending cuts will have to occur in just six months instead of nine. The defense cuts will have to be bumped up to 13 percent – a level that outgoing Defense Secretary Leon Panetta calls a “disaster.”

That’s going to affect defense-contracting companies quite a bit – again, in theory. And we may already be seeing some evidence of a rollback in some key defense stocks.

In reality, though, the sequestration requirements may not fall as heavily on the Pentagon as some expect. Why? Because defense spending is routinely funded even with no budget, much less a small one.  Congress has not passed a budget in years – yet they are still able to pass continuing resolution after continuing resolution, and pass additional appropriations as needed.

Further, Defense policy is not driven entirely by budget. Major decisions like force structure, troop levels, the number of ships the Navy requires and new weapons systems to be funded or acquired en masse are mission-driven, largely through a process called the Quadrennial Defense Review. The next QDR is due in 2014.  Nevertheless, some observers are already noting that budget uncertainties and the threat of sequestration are already undercutting the QDR process itself.

So what should investors do?

Now the real question: Should you go long or short?  As always, that depends on whether you believe that any firms’ revenue cuts caused by sequestration have already been priced into the stocks.  So if the biggest movement is going to happen in the defense industry, how does an investor play it?

Well, there are many choices, but the simplest answer is to play the ETFs.  In short, however, there is little upside left here – and plenty of downside.

Disclaimer: The views and recommendations in this piece are held by the individual contributor and do not reflect the opinions of NerdWallet as a whole.

Congress Image courtesy of Lissandra Melo/Shutterstock.