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Why Investors Aren’t Panicking (Yet) Over Sequester

Michael Santoli

Has Washington lost its knack for triggering market tantrums with invented budget crises?

In just four days, a package of automatic spending reductions devised to be so distasteful to both parties that they wouldn’t possibly be allowed to occur will almost certainly be allowed to occur. This is the so-called sequester. It amounts to $85 billion in annual federal spending reductions, or about half a percent of GDP, and all of official Washington now seems resigned to the fact that no budget deal will head off their arrival.

So then, why are the major stock indexes still challenging five-year highs rather than being knocked around by every headline about policy dysfunction and likely fiscal “anti-stimulus?”

There appear to be at least three broad reasons that the investors are facing this deadline with less anxiety than they did during the 2011 stalemate over the debt ceiling (which lit the whole sequester fuse in the first place) and the brinksmanship over the “fiscal cliff” in December.

We’ve been here before, and panic was not rewarded

Anticipatory market selloffs took nearly 20% out of stock values in the summer of 2011 and gouged a quick 7% from the Standard & Poor's 500 index at the end of 2012. The first swoon over the debt ceiling and downgrade of the United States’ credit rating – along with a wobbly Europe and slowdown fears here – ended with a deadline deal, which ushered in a monster stock-market rally in late 2011 and into early 2012. The slapdash Jan. 2 agreement on taxes likewise made the worriers appear foolish as stocks show higher out of the gate in 2013.

On some level, investors have been conditioned not to get scared out of the market by the maddening games of budget chicken in D.C.

The details of how sequestration will hit the economy are also allowing for a calmer market response. Unlike the debt ceiling measure or the failure to pass the bank-bailout bill the first time around in 2008, sequestration holds no chance of sudden, deep financial-market disruption or forced selling.

Sure, $85 billion is a big number, but that’s the annualized cutbacks for the fiscal year ending Sept. 30. Agencies have had lots of advance notice, furloughs and service cuts will be imposed incrementally, and the affected government bodies are so broadly dispersed that no single effect will be particularly devastating economically.

Economist Don Rissmiller of Strategas Group figures few cuts will be felt in March, the total “fiscal drag” will be some $42 billion through September, and there remains the chance that Congress can mitigate the impact in the negotiations of a “continuing resolution” to keep government funded before the current one expires March 27.

All else being equal, the belt-tightening will hurt, but alone it won’t likely dip the economy into recession. Perhaps, at minimum, the market is suggesting there's no need to get worried until the run-up to a potential government shutdown, or yet another debt-ceiling argument in the summer.

There are offsets to the fiscal headwinds

Though less dramatic than the widely watched federal budget showdown, state and local governments were reducing outlays and payrolls substantially for most of the economic recovery that began in mid-2009. By some measures, this state and local fiscal drag amounted to 0.4% of national GDP in 2010 and 2011, and somewhat less last year. True, the sequester will pressure state budgets anew. But more broadly, the public sector outside of Washington is about to stop restraining the economy for the first time since the recession.

Other economic drivers also are picking up as D.C. is poised to turn down the spending (very modestly). Residential fixed investment – the building of homes – should rise by more than half the amount the sequester will withhold from the economy, as just one example.

The market isn't up on economic momentum, anyhow

Stocks have been gaining due to a combination of a stabilizing global economy, massive central-bank stimulus efforts and an increase in investor and business-owner risk appetites, now that the big fear of another crisis-like economic meltdown has faded. With this backdrop, a subpar U.S. economic growth pace is good enough, so long as private-sector profits hold up.

This doesn’t mean the markets are inoculated against economic disappointment, though. Recent evidence of a tired consumer -- exemplified by Wal-Mart Stores Inc.'s (WMT) tepid recent results -- has helped restrain the market’s progress. With unemployment checks about to shrink under sequestration, government workers starting furloughs, the payroll-tax restoration pinching take-home pay and gasoline prices marching higher, the risk to the “slow-but-steady” growth story is growing.

Investors can shrug off the slight sting of the sequester cuts alone, for a while. But stronger hints that the broader mix of restraints on spending is undermining an economic and corporate-earnings acceleration in the second half of 2013 would not likely be taken well by the market.

Follow me on Twitter @michaelsantoli.