News / Economy

US Markets Take Spending Cuts in Stride

Specialist Patrick Kenny, foreground right, works his post on the floor of the New York Stock Exchange, March 1, 2013.
Specialist Patrick Kenny, foreground right, works his post on the floor of the New York Stock Exchange, March 1, 2013.
Broad spending cuts designed to hit most U.S. government programs with all the subtlety of a sledgehammer are set to take effect at midnight Friday, yet investors have so far barely batted an eyelash.
The $85 billion in across-the-board "sequestration" cuts were expected to eventually cause airport delays, disrupt public services and result in lower pay or layoffs for millions of government workers.
What they were not likely to do, at least as far as financial markets were concerned, was cause enough damage to derail a U.S. economy that has lately been gaining momentum.
Some also saw the prospect of weaker growth and higher unemployment caused by the spending cuts making it likelier the U.S. Federal Reserve will keep monetary policy ultra-loose for longer.
"The stock market isn't worried. It's at five-year highs, and the sequester gives the Fed all the more reason to keep its foot on the gas," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
Markets have also had a long time to weigh how the sequester could affect growth and believe it will not trigger a recession.
"Most of us believe that sequestration is not something that will make us fall off the cliff, since the cuts will be worked in relatively slowly," said Bill Stone, chief investment strategist at PNC Wealth Management in Philadelphia, which has $115 billion in assets.
"Granted, no one really knows what will happen with sequestration, and there's always a general unease around the unknown, but even if the estimates are right and GDP drops by half a percent, that's not a fatal blow."
Stock markets in the U.S. and Europe edged lower on Friday on weak European economic data, though encouraging figures on the U.S. manufacturing sector helped temper losses.
The MSCI world stocks index fell 0.46 percent on Friday, while the U.S. dollar rose 0.6 percent against a basket of currencies, its highest in more than six months.
However, the implications of the spending cuts for the world's biggest oil consumer sent crude oil prices lower.
U.S. crude oil fell about $1.51 a barrel to $90.54 while Brent crude traded at $110.35, off session lows.
Wall Street stocks traded nearly unchanged, paring losses after data showed that the pace of growth in U.S. manufacturing rose to its fastest in more than a year and a half in February.
The benchmark Dow Jones industrial average is less than 1.0 percent below a record high, up more than 7.0 percent this year. The more widely followed Standard & Poor's 500 is less than 4.0 percent from entering record territory.
Even an index of stocks in a sector seen at the cross-hairs of the spending cuts, the Philadelphia Stock Exchange Defense Index, hit an all-time high on Thursday. The sequester will hit the U.S. military particularly hard, with defense programs set to be cut about 13 percent. Yet the index, down 0.04 percent on Friday, has gained nearly 7.0 percent this year.
Investors said continued support from the Fed, after Chairman Ben Bernanke mounted a strong defense of the central bank's stimulus policy this week, would blunt the cuts' effects.
What's more, markets have been down this road before. In late 2012, investors and CEOs fretted over fears that the sequester, initially set to take effect in January along with $500 billion of tax increases, would cause a new recession.
A deal struck by Republicans and Democrats on New Year's Day averted most of the tax hikes but postponed the spending cuts until March 1. Major U.S. stock indexes rallied anyway, with the S&P 500 up 6.0 percent and the Dow up 7.0 percent this year.
Economists are not as relaxed. Many say government belt tightening will put a brake on growth this year, whether or not the sequester happens.
The Congressional Budget Office, whose calculations are the building blocks of many Wall Street forecasts, estimates fiscal tightening will knock about 1.5 percentage points from economic growth this year.
The spending cuts from the sequester make up a third of that, or 0.6 percentage points. A tax hike enacted in January will also drag on the economy, as will other spending cuts.
The labor market would also suffer, ending the year with 750,000 fewer jobs than it would have if the sequester were avoided, according to CBO estimates.
To be sure, these worries have pushed some investors into the relative safety of U.S. government bonds, with the benchmark 10-year yield slipping to 1.84 percent this week after hitting 2.06 percent, its high for the year, on Feb. 14.
"There are concerns about the sequestration causing a dramatic slowdown in the economy," said Dan Heckman, senior fixed-income strategist at Minneapolis-based U.S. Bank Wealth Management. "The budget negotiation related to the sequestration adds a great deal of uncertainty."
Bernanke, speaking to lawmakers on Wednesday, urged Congress to try to push spending cuts further into the future to shield a fragile economy.
"If you slow the economy, that hurts your revenues," he said. "That means your deficit reduction is not as big as you think it is."
Many investors, though, say the cuts, while annoying and painful, are too small a percentage of federal spending to do serious damage to the economy or have much impact on the deficit, which has exceeded $1 trillion for four years.
Still time on the clock
The question appears to be the duration of the budget cuts. If it is only a few weeks, the impact on growth and on employment could be marginal because some budget cuts will not translate into immediate spending cuts.
The Defense Department, for example, will probably not begin furloughing some 800,000 civilian workers until late April, after which these workers will work one day less per week. Budget cuts for capital spending could also be delayed.
The CBO estimates that only about half of the $85 billion in budget cuts planned from March through September would translate into lower spending during that period.
Once the furloughs and other spending cuts take hold, though, workers will feel the pinch, especially the 2.8 million people employed by the federal government.
"Their income is going to shrink considerably," said Omair Sharif, an economist at RBS in Stamford, Connecticut.
Tim Ghriskey, chief investment officer at Solaris Asset Management, said he thinks markets are betting all this will force Republicans and Democrats to the bargaining table.
President Barack Obama met congressional leaders in the White House on Friday for last-minute budget talks, but no deal was struck.
"The grace period is probably a month or two," Ghriskey said. "But if it becomes clear that these arbitrary cuts are starting to do damage and there's no sign of compromise, that's when the market could start to react."

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