The Sequester: What Investors Need to Know

ETF Trends

Absent some quick progress in Washington over the next few days, the sequester– $85 billion in across-the-board federal spending cuts – will most likely hit this Friday.

While some of the cuts may be rescinded during March budget negotiations, at least some should stick.

As I write in my most recent weekly market commentary, despite their modest size, I expect that the cuts will be, at least temporarily, disruptive to the US economy and markets. Here’s why:

  • The Sequester Will Increase Fiscal Drag. As I mentioned last week, fiscal drag from the spending cuts alone is likely to be as high as 0.5% of US GDP. But fiscal drag from the cuts and recent tax hikes combined is likely to be around 2% of 2013 GDP, a large hit for an economy that barely grew by that much last year.
  • Today’s Low Interest Rate Environment Could Strengthen the Sequester’s Impact. There is also some evidence that the damper on the economy from spending cuts and higher taxes could be even greater when interest rates are close to zero and other countries are going through the same austerity exercise.
  • Slow Growth Should Slow Stock Market Gains. The sudden drop in government spending and recent taxes will likely mean modestly slower US growth during the first two quarters of this year. I expect this, in turn, to slow equity market gains as we move into March.

Given that the overall economic environment is likely to deteriorate a bit in the near term thanks to significant fiscal drag, market gains will get tougher from here and investors should be prepared for a rocky road ahead. In other words, last week’s market selloff and volatility spike could be a sign of things to come over the next couple months.

That said I still believe stocks can move higher in 2013. While investors were rightly concerned last week about slow growth, their worries about the end of the Federal Reserve’s quantitative program were premature. In fact, if the Sequester hits as I expect, the Fed would be even more likely to keep up its asset purchase program in an effort to offset the drag on economic growth.

The upshot? As at least some of the sequester’s resulting fiscal drag is likely to be temporary, investors may want to view any equity market volatility as a long-term buying opportunity.

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.

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