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 (^DJI 1.14%) 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.
