On the eve of sequestration, Wall Street doesn't seem terribly concerned about the impact of the budget cuts.
"Investors seem to have only woken up to the fact that it is hitting – but I don’t think they will care," says Mark Spindel, founder of Potomac River Capital. And so far, the equity markets have stayed bullish: As Politico's Ben White points out, the Dow closed yesterday just 100 points shy of its record high in 2007.
That's not to say that investors are thrilled about the automatic budget cuts—they just don't think the economy and the markets will be in upheaval because of them. "Wall Street is looking at out of corner of eye with disdain," says Tobias Levkovich, chief U.S. Equity Strategist for Citi Investment Research, but investors are "not going to freak out." After all, the contraction under the fiscal cliff deal was much bigger—greater than $600 billion—and the markets remained fairly calm. "That wasn't disastrous, so why this would be disastrous?" Levkovich says.
Analysts point out, moreover, that the $85 billion in budget cuts aren't all real "cuts" to current spending. Rather, they are cuts to budget authority—"how much money Congress allows an agency to commit to spending in the future"—rather than "how much money actually flows out of the agency in a given fiscal year," as The Fiscal Times explains. Citi's Levkovich estimates that the actual spending cuts to current budget outlays will be about $45 billion, while IHS Global Insight sets it higher at about $66 billion.
And many anticipate that Congress and the White House will ultimately find a way to prevent the full sequester from taking effect. "It is doubtful that the full $85 billion will be trimmed from spending in its current fashion since the need for a continuing resolution will compel some degree of negotiations between the White House and the GOP even if their relationship remains frosty," Levkovich and his colleague conclude in a recent Citi's research note.
However, there are some dissenting voices on the Street as well: Barclays' Michael Pond, head of global inflation-linked research, believes that markets are being too blasé about sequestration, arguing that the fiscal contraction will have a real drag on growth that investors haven't accounted for yet. Pond agrees with the Congressional Budget Office's estimate that sequestration will result in a 0.5 percent drag on GDP growth this year, at the cost of 750,000 jobs.
Even if the sequester is undone, he explains, it's likely to be replaced with another form of fiscal contraction that will slow growth. "It will either be a fiscal drag related specifically to the sequester or a fiscal drag that's something else—an alternative set of cuts or tax increase," says Pond. "It may perhaps be more appropriate or more efficient than across-the-board cuts, but it's still a fiscal drag."
Pond believes, moreover, that markets still haven't priced in the full impact of the fiscal cliff deal, arguing that the payroll tax hike and other tax changes under the bill are likely to dampen consumer spending this year. "We thought the market reaction to the fiscal cliff negotiations was too optimistic," he says. In terms of personal spending, for instance, "we will be eventually see the bite of the payroll tax increase."
Both bullish and bearish analysts agree that investors will be much more concerned about the next budget deadline, March 27, when the continuing resolution expires—with the threat of a government shutdown if legislators can't pass a budget compromise. "The discord could unnerve markets even if an eventual compromise is assumed, although the 1995-96 shutdown did not result in a S&P 500 correction," Citi's research analysts conclude.