Handling finances the American way: What is sequestration exactly?

The American financial system is in an uproar and sequestration is the new “it” word on the streets of Washington. But what is sequestration exactly and how does it affect the American economy and the rest of the world?

Sequestration

Sequestration is a surgical cut to government spending programs that doesn’t take into account what specific programs are being cut. These across-the-board cuts in government spending will total about USD 85 billion in 2013. Surprisingly (at least for the United States) the largest piece will come from defense, where spending will decline by nearly USD 43 billion or 8 percent and this in a country that values its troops, national security and its war on terror above anything else. Domestic discretionary spending will be cut by USD 29 billion or 5 percent, while  “other” spending will drop USD 4 billion. After 2013, if nothing is done to reform the deficit, the cuts will continue with the amount of USD 110 billion per year all the way through to 2021.

The unique feature of the sequester of 2013 is that the law requires the cuts to be applied evenly to every program, project and activity on the US government spending list.  So while the Food and Drug Administration will see its funding go down by USD 206 million, versus nearly USD 1 billion at NASA and USD 6.3 billion in military research, these declines are all proportional to their overall spending budgets.

Effects

The reduced flow of money from the government into the economy will certainly have real effects. Even though economists project an improved GDP growth for the second half of the year, the second quarter GDP is likely to decline by one to one-and-a-half points.

There has been a lot of hesitation in earnings reports and quarterly outlooks due to the expectation that the sequestration was coming. The general uncertainty in the direction the American government ultimately decides to go is constantly adding an x factor to everyday business decisions and strategic planning for companies. But so far, stock  market performance seems to indicate that businesses are largely ignoring Washington’s half hearted movements. Many businesses, large and small, were obviously worried in late 2012 about the risk of something like sequestration and adjusted their spending plans accordingly.

Market specific impact

Strategists at Bank of America  estimated that the net impact of the cuts would be about 1 percent to the S&P 500. This rate does not exactly represent a seismic shift in an economy but becomes more significant on a cumulative basis and, in a soft economy, it can trigger a more prolonged recovery or even a new recession.

Clearly the biggest impacts and risks will be felt by companies that generate the majority of their profits through governmental contracts. One such area is the defense sector. Unlike with negotiated cuts of budget in the past, there won’t be as much flexibility to de-prioritize certain kinds of spending in favor of others. That’s bad news for companies manufacturing weapons and other supplies for the Department of Defense, that generate 80 percent or more of their revenue from the government.

There will likewise be impacts in the healthcare and life science industries. Hospitals and healthcare service providers will have to adapt to lower payments coming from the government, which will result in increased fees for patients, decrease in spending power towards drug/device suppliers and ultimately lower margins.

In general, many consumer companies in the United States and globally will feel the impacts of US governmental spending cuts. These incremental spending cuts will ultimately find their way to consumers in the form of more expensive services or lower earnings. Ultimately it will result in less money for discretionary spending for the population and less money going toward consumer goods and services. This has the potential to become a challenging problem for some industries like entertainment and travel as well as basic needs like food and housing.

Implications for investors

The current situation offers itself for the debate on the benefit of foreign stocks in one’s portfolio and a close study on how different markets are related. Incorporating foreign securities into investment strategies can be an alternative if investors are trying to escape the uncertainty of just one market. Even though the global economy will feel a decline in U.S. growth, the on-the-ground realities in countries like Mexico, Brazil, Japan and China are not so closely tied to the sequester. Probably the market that is closest tied and therefore affected by the developments in the US is Europe. Investors should use this opportunity to reevaluate their global investment exposures and consider adding more foreign stocks.

The recent developments also offer a possibility to reexamine the industries one’s portfolio is heavily tied to. It is safe to assume that consumer stocks will take a hit long-term as consumer spending is decreasing while tech stocks have a generally low exposure to sequester and are expected to perform reasonably well.

Afterthoughts

The talk of the “fiscal cliff” that started back in 2012 and the inability of the Congress and the White House to find any type of compromise concerning the resolution of the financial impasse that the US is in, lead to the thinking that these forced spending cuts were secretly desired by both Republicans and Democrats. These measures are not directly attributed to just one specific party and therefore the blame is equally shared by all and no one at the same time.

The impact of the sequester will be unquestionably felt in America and around the world but its effects might be offset by growth in overseas’ markets through international sales for American multinationals and foreign investors coming to the United States and investing here.

It could negatively affect the academic community worldwide as grants and fellowships as well as expenditures for R&D are being reduced or cut completely but it could also empower private investors to consider education and research as part of their investment strategy.

By Olga I. Abrosimova

Olga I. Abrosimova holds a BSc in International Business from the Maastricht University School of Business and Economics. She sits on the Board of Directors of Best Buddies New York and is a member of Urban League Young Professionals New York.  An avid traveler, blogger and aspiring programmer, she currently resides in New York.

 

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