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Why Wall Street Has Tuned Out Washington

The sequester is going to hit tomorrow, and $85 billion in across-the-board spending cuts for defense and discretionary programs are expected to be devastating to the economy. Yet Wall Street hasn't blinked, climbing 1.3% yesterday and making small gains today. Why the apathy toward such "devastating" cuts?

For more than five years, Wall Street has dealt with brinksmanship in Washington, and the act is getting old. The bank bailout failed until investors panicked and markets plunged. The economy tanked, and even then a stimulus package was like pulling teeth. There was the debt ceiling debate, then the original sequester, the fiscal cliff, and now the actual sequester.

When Washington has actually gotten something done, it has always been a last-minute patch-up, rather than a structural overhaul. So the market has come to expect little more from Washington. As we head toward the sequester, investors have looked past what is or isn't being negotiated between the White House and the houses of Congress, choosing to focus on more important things.

Fool me once...
The market used to care about these events. In the weeks surrounding the debt ceiling negotiation in 2011, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) lost 15.7% of its value. The day after Standard & Poor's downgraded Treasuries from "AAA" to "AA+," the Dow tanked 5.5%. Investors and the media were abuzz with the goings-on in Washington. CNN's Erin Burnett did a segment every day about the U.S.'s lost credit rating, pounding into our heads how important it was to do something to get it back. Still, little was done in Washington to address revenue or spending until the fiscal cliff was upon us.

By the time we went over the fiscal cliff (which we did briefly) on Jan. 1, 2013 investors had stopped caring about the daily brinksmanship debate. Stocks didn't move wildly higher on hopes of a deal or plummet when negotiations fell apart. Consensus was that the fiscal cliff was bad and that we would avoid some, not all, of it eventually.

So here we stand two months later after another delay in dealing with the same problems that plagued us in the summer of 2011. No grand bargain has been reached since then, and it's unlikely there will be one in the next 24 hours. Even if the sequester isn't modified in the next few weeks, we'll be back here again on May 18 when a temporary suspension of the debt ceiling expires. Will stocks drop going into the debate like they did in 2011, or will markets shrug them off like they did over the past two months? My money's on the latter. Washinton already fooled the markets with that game once, and the second (or is it the third?) time around, investors have moved on to more pressing matters.

The problem isn't as big as it once was
Although Wall Street hasn't reacted to Washington lately, we have to consider that the deficit problem isn't as big as it was just a few years ago. In 2009, the country ran a $1.41 trillion deficit. This year, the Congressional Budget Office predicts the deficit will be down to $845 billion, or 5.3% of GDP, and if Congress does nothing (which looks likely) by 2015, the deficit will be $459 billion, or 2.4% of the economy.

These numbers look large, but in the grand scheme of the world's biggest economy they're not anywhere near uncharted territory. Since 1980 the federal government has run a deficit larger than 3% in 18 years -- more than half of the time. A 3% deficit is widely considered to be sustainable, because if the deficit grows as much as or less than the economy does, then the debt-to-GDP ratio will fall. And 3% should be an attainable long-term level of economic growth -- at least, that's the theory at least.

Investors are focused on the size and scope of the problem. A 10% budget deficit is a long way from balanced and could bring on a debt crisis if unchecked. In 2008, the economy was about to collapse if the banking sector wasn't bailed out. In 2011, we still had more than a $1 trillion deficit, and judging by bond investors' reaction to Europe, we couldn't afford to lose the faith of those buying our debt. These were huge problems, and that's why the market swung wildly on every move Washington made.

Today, the economy and the budget are in very different places. A 5.3% budget deficit is within arm's lengths of standard operating procedure for Washington, and with deficit hawks still carrying weight, it's nothing investors need to get worked up about on a day-to-day basis. The deficit will come down if the economy is strong, and that's what's been driving the market lately -- not the negotiations in Washington.

Cuts are expected
Investors also know that cuts are coming and have prepared themselves. Discretionary spending and defense will be first, and if the political will ever materializes, entitlements will be on the table. The market knows this and has been expecting it for some time. Defense stocks, medical stocks, and government contractors have all priced in cuts that are likely coming.

We also know that federal-government spending will be a drag on the economy instead of a boost, as it was during the financial crisis. As consumers and local governments have slashed spending over the past five years, the federal government has picked up the slack with deficit spending. Now it's time to pay the piper, and federal spending is falling while the rest of the economy picks up the slack. That's why investors have been focusing more on private employment, consumer spending, and housing, rather than numbers like GDP growth that are affected by government spending.

Washington doesn't scare Wall Street anymore
Investing is just as much about psychology as it is about the analysis of the economy and stocks. Conventional wisdom was that stocks would drop as we went over the fiscal cliff, just as they had done with the debt ceiling and even the election. But the psychology has changed, and now brinksmanship is how business is done. For now, investors are fine with that.

We'll hear more about the sequester in coming weeks, and then we'll turn to the debt ceiling. But instead of panicking when negotiations in Washington come to a standstill, the market is likely to look past it, just like it has done the last two months. Washington has cried "wolf" one too many times, and now no one is listening.

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Read/Post Comments (23) | Recommend This Article (40)

Comments from our Foolish Readers

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  • Report this Comment On February 28, 2013, at 7:12 PM, xetn wrote:

    According to Forbes, The $999 billion Sequestration actually increases spending by $110 Billion.

  • Report this Comment On February 28, 2013, at 7:22 PM, chris293 wrote:

    Excellent take on the games Washington plays with the economy. Good honest businesses never needed the help of Washington for the most part, and the government thur Congress squeeze out rules and laws to gain control for their own or some special interests' profit. The real losers are the American people, especially our seniors if they never were able to set aside any savings for that 'rainey day or days' which some might say is caused by the bubble machines in Washington.

  • Report this Comment On February 28, 2013, at 7:32 PM, topbeancounter wrote:

    Of course, none of this has anything to do with the President's race I'm sure... yeah right, and pigs fly.

  • Report this Comment On February 28, 2013, at 7:38 PM, TheRealRacc wrote:

    Thank you for the optimism.

  • Report this Comment On February 28, 2013, at 8:35 PM, HerrGlock wrote:

    Nice optimism, only when all the Fed's money printing is over and inflation escalates, as it must....the result will be increased interest rates, and the federal debt will be eventually be more than the annual revenue that the government takes in.

    Then Wall Street will not ignore our illustrious government, you watch

  • Report this Comment On February 28, 2013, at 8:38 PM, woolibulli wrote:

    A few more simple things could start hacking at the deficit. A means test for Social Security an possibly Medicare. Stop letting Hedge fund directors and others take their pay as if it was Dividends.

    Put a tax on all of that offshore money. Last one may be more complicated. :0)

  • Report this Comment On February 28, 2013, at 8:53 PM, eldetorre wrote:

    The only problem with means testing medicare and social security is that it will just expand the cottage industry now known as medicaid planning. The legal costs will rise as people fight cuts. Administrative costs will rise as well. It is much more expensive to means test programs and effectively develop and measure criteria.

    My solution is this.

    1-Mandatory medical savings accounts by percentage of income no exceptions. Medicare only kicks in upon exhaustion of account. Rich people will have more in their accounts.

    2-Social security should be converted to a defined contribution system. The exact equivalent of a a private account investing in government debt. You only get out what was contributed by you and your employer plus interest on the debts. The same as every other holder of US debt.

  • Report this Comment On February 28, 2013, at 8:59 PM, hank321 wrote:

    The economy has not grown by 3% in years, and you say that a deficit of 3%, which we MIGHT reach in some years, is fine eh?

    Sorry, I do not buy your analysis.

    The cuts in the sequestration are not ideally distributed, but cuts, especially to bloated entitlements, are better than even more tax increases at this point. The austerity goes a bit too far too quickly,...but better that approach than continued gross bleeding ,...which is NOT sustainable. The Keynesian lies do have a consequence, eventually.

  • Report this Comment On February 28, 2013, at 9:10 PM, eldetorre wrote:

    Entitlements are not bloated. This is a lie. People have paid into SS. They are ENTITLED to every thing that was contributed just as every other holder of government debt is entitled to be repaid plus interest.

    Most of our debts are due to war spending, financial system bailouts, cold war (against communism) etc. all of which benefited the rich more than any other class. They should pay in proportion to their level of benefits realized.

  • Report this Comment On February 28, 2013, at 9:18 PM, ynotc wrote:

    You forgot that in years past our total debt was not equal to or greater than our total GDP.

    You also forgot that at the current historically low interest rates that he government is currently able to borrow that about $.40 of every dollar goes towards interest payments.

    What happens when we revert to the mean (interest rates increase) as they invevitably will.

    Maybe Wall street does not care now but ultimately they will get spooked and when they do watch out.

  • Report this Comment On February 28, 2013, at 10:01 PM, robinrobar wrote:

    It is Wall Street that controls Congress and not, as is implied, the other way around.

    Ummm... let me rephrase that: It's the Corporations that control Congress and not the other way around. The Corporations are humming along, so why would WS be upset at the wusses' actions (ummm...inactions)? Besides, what the Corp's want, they've just gotten: a cut in the outgo. That makes all the more sense for their taxes to be cut. See: win, win; so why be upset?

  • Report this Comment On February 28, 2013, at 10:25 PM, HempyD wrote:

    Is Wall Street still taking the $83 billion? Cut that off and that'll take care of the sequestration problem.

  • Report this Comment On February 28, 2013, at 10:37 PM, TMFSelzhanik wrote:

    An $85 billion cut in a $4 trillion budget? We're supposed to worry about that? My taxes and health insurance bill rose by more than 2.5% of my annual salary as of January 1. Not to mention gas prices and other inflated costs. Yet I'm figuring my budget out without any drastic catastrophes. Seems like the most powerful man in the world might have the intelligence to figure this out without much effort or draconian consequences.

  • Report this Comment On February 28, 2013, at 11:12 PM, BentMike wrote:

    The past brought us quite a bit of unemployment. Interesting that most of the private sector jobs have returned. Most of the additional folks out of work since '08 are local, state, and federal employees. The numbers are about equal, around 200K last I heard. 200K fewer gov't jobs, 200K more unemployed. Those lost gov't jobs are a big drag on the economy.

    So what happens what 9% is lopped off from the federal gov't?

    I bunch more lost jobs and no where for them to go any time soon. Services not provided, human resources mothballed. It is not hard to see what will happen to the economy next.

    I swear we have the dumbest bunch in congress that has ever been. And we have allowed them to gerrymander so now they don't get voted out. Lovely. This might do it though.

  • Report this Comment On March 01, 2013, at 12:45 AM, daolag wrote:

    I am afraid, your focus on "deficit" is misleading! What about the $16 trillion? That does not matter??? Should we continue to spend recklessly and expect to prosper? Only fools borrow money from their "enemies" to fund their debt. America has got to get out of "print-spend- and borrow" money you don't have. Fed is driving the market crazy and not the fundamentals. Fools need to do less foolish research!

  • Report this Comment On March 01, 2013, at 2:24 AM, moneytrail wrote:

    Sequestration is far from "devastating" despite the pathetic, embarrassing Chicken Little display of the Pres. This year it will amount to about $44 bil, or 1.2% of our morbidly obese budget, with the remaining cuts on spending increases coming in future years. The best part of it is that our 24/7 campaigning Pres conceived the scheme and is swinging from his own rope. Wow, whatever happened to presidential leadership?

    Your sanguine view of our "diminishing" trillion dollar deficits is unrealistic. Every 1% increase in financing costs will add almost $200 bil to the deficit annually. Do you really think interest rates will remain tame with the Fed recklessly pumping more than $1 trillion/year of liquidity into the economy & the pres adding another trillion in borrowing?

    Regarding the comments about social security and Medicare entitlements, most recipients draw 2x to 3x more than what they pay into the system, with current workers picking up most of the tab. How long do you think that Ponzi scheme can last?

  • Report this Comment On March 01, 2013, at 8:45 AM, jvgfool wrote:

    Are business in denial? What happens when these thoughtless cuts hit the streets and customers cut spending? I guess that's the big question.

  • Report this Comment On March 01, 2013, at 9:08 AM, devoish wrote:

    "Regarding the comments about social security and Medicare entitlements, most recipients draw 2x to 3x more than what they pay into the system, with current workers picking up most of the tab."

    That is why it is a good investment, and profitable is how all investors hope their investments work out notwithstanding the fact that investment advisers promise better.

    So what happens what 9% is lopped off from the federal gov't?"

    Federal spending represents less that 20% of GDP (18?) 10% of that represents 1% of GDP so GDP falls 1%.

    If those cuts are financed by laying off 1% of the 140,000,000 US workforce then 1.4 million people become unemployed, unable to pay investors in mortgages, car loans, unsecured loans etc.They also become unable to support investments in the earnings of retail companies and so forth.

    If those cuts are financed by cutting hours, or payscales then instead of layoffs then a the pain is spread out beyond the 1.4mil to additional families. - More people and investors lose, but they all lose less, each.

    "You also forgot that at the current historically low interest rates that he government is currently able to borrow that about $.40 of every dollar goes towards interest payments.

    What happens when we revert to the mean (interest rates increase) as they invevitably will."

    People with fixed rate mortgages who also hold onto their jobs at their current pay scale will hold on and continue paying investors for their investments in mortgages.

    People with ARM's which represent about 20% of outstanding mortgages in the USA, with a principle value of over $5t of the $13t in mortgage principle outstanding will spend more of their incomes servicing investors in mortgages rather than servicing investors in retail and discretionary spending.

    Additionally the 60m US households with CC debt will see the payments on their average outstanding balances of $15,000 increase as these rates are not fixed. Investors in CC debt will be rewarded or punished depending upon the ability of the companies they have invested in to attract qualified borrowers, which is based upon the ability of ratings agencies to assess creditworthiness. Investors in retail will probably be punished as more discretionary income is shifted to non-discretionary debt service.

    However, all of that kind of suggests an honest marketplace where investors are simply trying to position themselves for profit based upon events beyond their control by timing the shift away from low interest rates and making the "right call" as or before interest rates increase.

    I don't believe in that.

    I believe the "right call" is going to be from an investment bank to the fed, after the investment bank is positioned to profit from rising interest rates. More like telling the fed it is time to raise rates, as opposed to anticipating when the fed might raise rates.

    That is what I will continue to believe in, until potheads are released to make room for investment bankers.

    Best wishes,


  • Report this Comment On March 01, 2013, at 9:13 AM, mikecart1 wrote:

    For anyone thinking the furloughs are not that big of a deal, I will love to see where the market is next quarter. The federal government is the largest company in the entire country. If everyone is going to take a 20% hit in pay the next 6 months, you can go ask someone else to shop at your stores, eat at your restaurants, and buy your products. The market is going to feel the pain big time. Anyone that thinks otherwise must assume some other group of the country pays for all this useless, overpriced, stuff...

  • Report this Comment On March 01, 2013, at 11:47 AM, hank321 wrote:

    The comments by eldetorre above are simply as ignorant as ignorant gets. Entitlements have been obscenely bloated for decades, and the rot and corruption are getting worse, not better.

    All patriotic, knowleable Americans are strongly in favor of DEEP cuts to wasteful public spending,...get the deadwood off of government payrolls at all levels. And the Governemnt has no business paying unemployment insurance for 99 weeks---people must work to support themselves and their families, and will do so, if they are not paid to remain unumployed, as so many are.

  • Report this Comment On March 01, 2013, at 3:32 PM, moneytrail wrote:

    The economy is already taking a hit because of the President's tax increases on all middle class wage earners, and the tax increases that punish successful investors and job creators.

    Laying off government employees is unnecessary, if the cuts are done intelligently. However, Bozo the Pres is trying to cause as much pain as possible to make an ideological point.

  • Report this Comment On March 03, 2013, at 8:17 PM, Loxly wrote:

    My so called entitlement costs me over $200 per month (with the Part D plan). And if I opt in to a "supplemental plan" to cover what Medicare doesn't cover it'll end up being over $340 per month.

  • Report this Comment On March 08, 2013, at 9:35 PM, J6R wrote:

    Yeah!!! We are 6 days into the disaster. Four of those days have been market highs. We choked the greedy,bloated government hog by 2.8% and the Dow is at an all time high.Choke the hog a little more;and,maybe Mr Market will have more cash. Remember:

    Government is not the solution,

    government is the problem...!!!

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