What the 'sequester' means for stocks

Stock markets have shrugged off the furore over the painful package of cuts in America, known as the 'sequester'. But are investors right to be so sanguine?

"The assumption was that not even Washington is dumb enough to do this", says Randall W Forsyth in Barron's. "Wrong." On 1 March, the "sequester" spending cuts worth $1.2trn over ten years kicked in in the US. The squeeze this year amounts to around $85bn.

The heavy-handed cuts will cover areas including defence, environmental protection, and education. Staff in many state agencies will be put on unpaid leave. The sequester is designed "to exact as much inconvenience and misery as possible for relatively minimal shrinkage" in the huge deficit.

The White House and Congress agreed to the sequester in 2011 as an incentive to come up with a more rational, long-term plan to curb America's deficit and public debt mountain. But instead of concentrating minds, it has just entrenched divisions and become a political football. Democrats say the cuts will be hugely damaging; the Republicans dismiss them as barely a scratch.

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Markets have largely shrugged the latest fiscal drama off. The Dow Jones index has reached a new high. "We made it through the fiscal cliff and payroll tax hike," says James Paulson of Wells Capital Management. "So there's a sense that this is Groundhog Day for investors."

The impact on growth

But are investors right to be so sanguine? They seem to be assuming that the sequester won't have much impact on the economy. The cuts "are more blip than bomb", as Daniel Indiviglio puts it on Breakingviews. Most estimates say that the sequester will shave 0.5% off this year's GDP growth figure.

But that isn't the full extent of the fiscal squeeze facing America this year. Throw in the end of the payroll tax cut and the rise in tax rates for higher earners, and the contraction is worth 1.9% of GDP. And it's not as though America is going gangbusters anyway. Only the very bullish forecasters have pencilled in a GDP growth forecast above 2.5% in 2013.

With Europe and Japan struggling and China slowing again, "there is little strength elsewhere in the world to compensate if the US stumbles", says the FT. Analysts' estimates for 2013 earnings are falling, notes Stan Shipley of International Strategy & Investments.

Will the sequester be reversed?

Many are pinning their hopes on an agreement to reverse the sequester in the near future. The cuts are staggered overthe next few months and people are unlikely to notice them just yet. So that gives Washington more time to keep arguing and come up with a better plan.

The next deadline is 27 March, when a resolution that funds the government's operations expires. It must be renewed or a broader budget agreed. Without a deal, all non-essential federal government operations cease. Then there's a showdown over the country's legal borrowing limit due in the summer.

Given the entrenched partisanship in Congress, the gridlock looks set to continue, says Edward Luce in the FT. Get set for more last-minute wrangling over the debt ceiling. All this hardly sounds like good news for household or corporate spending, although it's hard to estimate the exact impact. Dysfunctional government has become "the biggest single threat to our recovery", reckons John Cassidy in The New Yorker.

So the American fiscal drama creates a headwind for growth, while high US valuations and dwindling earnings growth are further discouraging fundamental factors. Offsetting these, however, are generous helpings of liquidity from central banks. "Mad money trumps every other concern," says Kit Juckes of Socit Gnrale.

But the poor fundamentals make the markets all the more vulnerable to a reversal when the mood sours. Those keen to toast the Dow's new record with champagne may soon face a nasty hangover.