September has been one of the best months for the Dow Jones Industrial Average (^DJI 1.73%) in the past year. Buoyed by the European Central Bank's promise to support its debt-laden members and another round of quantitative easing from the Federal Reserve, a renewed sense of optimism has sent markets to heights not seen since 2007.
But looking past that good news, the original reasons for investor nervousness seem largely intact. Even if the EU survives, much of the eurozone is mired in recession, and it recently hit record-high unemployment rates.
Meanwhile, unemployment remains stubbornly high at home as the latest jobs report confirmed, and many cities and states are awash in debt and potential bankruptcy. Millions of Americans remain underwater on their homes, and the high levels of cash on corporate balance sheets seem to attest to big business's lack of confidence in improving economic conditions.
Finally, growth in China seems to be slowing faster than expected, as electricity consumption -- a widely followed indicator for industrial output -- has been flat in recent months.
But investors need only recall last year's debt-ceiling debacle to understand the real reason this rally looks so precarious. Faced with the generally routine task of raising the country's debt ceiling, Congress stalled in its attempt to win spending cuts, costing the U.S. its "AAA" rating and sending the Dow crashing 20% in just two weeks.
Well, Congress has again made our bed, and we may be forced to lie in it. Sequestration, originally devised as a last resort so extreme that it would force the congressionally appointed super-committee to come to a reasonable agreement on debt reduction, is fast looking like a reality, and it has been largely ignored by the media, Congress, and the market as the election has taken center stage. The drastic cuts, which would start next year, are not guaranteed, of course. But based on Congress' recent record, I'm not betting that a better solution will be reached.
What it means
First, sequestration would mean dramatic cutbacks to the defense budget totaling half a trillion dollars over 10 years and $55 billion in the first year alone, from a current budget near $700 billion. While congressional hawks like Sen. John McCain have said that sequestration "would destroy the military," the market doesn't seem to be buying it. Stocks of the major defense contractors still look strong. Addressing the House Armed Services Committee on the matter, Lockheed Martin (LMT 1.83%) CEO Robert Stevens said in July, "If sequestration happens, it will be a blunt-force trauma to industry and to America." Yet despite those remarks, Lockheed's stock is trading near its 52-week high. The same is true of Raytheon (RTN +0.00%), which a hit a fresh 52-week high earlier this month and is counting on international growth to balance any cuts from the Defense Department.
It's worth remembering that the sequester comes on top of $487 billion in already planned defense cuts, and layoffs will likely follow. Stevens said Lockheed Martin could dismiss as many as 10,000 workers as early as November, and one analysis -- conducted by a George Mason University professor, in conjunction with Chmura Economics and Analytics, on behalf of the Aerospace Industries Association -- concluded that sequestration could cost the country as many as 2.14 million jobs in a range of professions including teachers, nurses, and construction workers in just the first year.
Domestic programs
The Department of Defense isn't the only one dealing with potential rollbacks. A number of domestic programs face sharp cuts, including Head Start, child care, and HIV/AIDS programs, as sequestration threatens to remove $500 billion from nondefense programs over the next 10 years. On the chopping block are 2,300 research grants from the National Institutes of Health, 100,000 kids who would lose access to Head Start, and 80,000 more who would lose child care assistance. One study showed that 48,000 jobs in health care, 99,000 in construction, and 473,000 in manufacturing are at risk, as well as 617,000 jobs in the federal government.
Joining the chorus of those demanding that Congress act were the nation's mayors, who said that sequestration would depress GDP by $215 billion in the first year alone and slash workforce earnings by $109 billion. They also cited a Congressional Budget Office report saying the anticipated budget cuts "lead to economic conditions in 2013 that will probably be considered a recession." Finally, they warned that the austerity they've sustained to overcome the recession put them in a particularly precarious position, arguing, "We cannot bear the financial burden that additional discretionary spending cuts would require just to meet the most emergent needs of our constituents."
Foolish takeaway
The market seems to be betting that Congress will work out a better solution, but time is fast running out. The super-committee, appointed to form a bipartisan compromise on cutting the deficit, failed to resolve the matter last fall, and Congress has since taken little, if any, action to reach a lasting compromise. With legislators now in recess until after the election -- in one of the earliest election season adjournments since 1960 -- it will be up to a lame-duck Congress with its back against the wall to come up with a solution. Unsurprisingly, a number of other key bills are also on the docket, including the JOBS Act, postal-service reform, a decision on extending the Bush tax cuts, and a farm bill to replace the current law expiring Sept. 30.
Even if Congress is able to avoid sequestration, any alternative agreement is likely to hamper economic growth. This year was the fourth in a row with a federal deficit of more than $1 trillion, as the shortfall hit $1.1 trillion. The ratio of debt to GDP has reached its highest level since 1950, and the debt has ballooned to $16 trillion.
If anything is clear, it's that there are no easy answers.
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