While I typically focus my writing on dividend investing, the current federal fiscal climate has led me to the point of taking a step back to look at the larger picture of the U.S. economy. Living in the Washington D.C. area sequestration seems to be on everyone's mind, as it should be. If Congress fails to reach a budget deal by Friday (March 1st), the federal government enters "sequestration." This sequestration would mean that all federal agencies across the government would be subject to immediate budget cuts of 9%. Much of the news surrounding sequestration, and the budget cuts has centered around the Department of Defense as it will be faced with the largest budget cut and without a new budget must continue operating under the Continuing Resolution. Operating under a continuing resolution alone is a challenge for DoD, as it places additional restrictions on use and management of funds, but with the inclusion of additional budget cuts the situation becomes much more difficult.
The direct impacts of the 9% reduction in federal spending would be significant, but much of this has already been evaluated and priced into current equity prices. However, the indirect impacts would be much larger, and do not appear to be reflected in the markets at this time. The reduction in spending would not only hit those who are heavily reliant on federal spending, such as defense contractors Lockheed Martin (LMT) and Northrop Grumman (NOC), but many other companies throughout the nation that rely on federal contracts. Companies like FedEx (FDX), Pfizer (PFE), and AT&T (T) all received over $150 million in federal contracts in the past year, and would likely see some negative impact on their earnings in the quarters ahead.
Other indirect impacts exist as well, and the potential impact has not yet been completely identified. In preparation for the potential budget cuts, many federal agencies have notified their employees to be prepared for unpaid furlough days starting in late April. The expectation is that federal workers throughout the government could be subject to up to 22 unpaid days from late April through the end of the federal fiscal year. This equates to taking one day off per week without getting paid (a 20% reduction in pay). That 20% reduction in pay will seriously impact the take-home pay of federal workers, and cause a significant reduction in discretionary spending among the roughly 3 million families that could potentially be impacted.
Beyond simply the federal workers, the impact on those who work on projects contracted out by the federal government remains to be seen. Among contractors, there is a sense that federal agencies may ask for certain concessions, based upon what is allowable by law including reductions in billable hours or staff, to enable the agencies to achieve the necessary spending levels. Reductions in billing and staffing on contract work would cause increases in unemployment, and further reductions to discretionary spending throughout the United States.
While the sequester officially hits on Friday, the impact of this failure of Congress likely will not be fully realized until May or June. The Washington D.C. metro area is bracing to take an oversized hit from this, as the greatest concentration of federal workers resides in this area, but the effects of sequestration will be felt throughout the country.
At this point sequestration would seem to be unavoidable. Congress has been unable to reach a budget deal in the months leading up to this point, and I remain pessimistic that the situation will change over the next three days. In the later months of 2012, and throughout January and early February, I remained optimistic that Congress would do its job and ensure a budget deal was reached to avoid the significant consequences sequestration would bring for the U.S. economy; however, over the past few months members of Congress have continued to disappoint and fail those citizens who elected them into their current positions. Although the U.S. enters sequestration on Friday, Congress will have the opportunity to pass a budget in the weeks ahead to avert much of the damage.
Despite the automatic spending cuts rolling into effect, Congress has the ability to put in place a bill that could mitigate much of the impact of the spending cuts and provide federal agencies with appropriate guidance for identifying and implementing reductions in the years ahead. Federal agencies have significant opportunities to achieve savings through making business operations more efficient and eliminating wasteful spending, but need time and guidance to implement the savings.
With the challenges sequestration presents for the U.S. economy, I will be waiting for additional clarity on the situation before adding more money to the market. I think the months ahead, late April - June, could represent a great buying opportunity for long-term investors; however, until a clear picture of the full impact of Congress's failure to establish a budget is apparent I will be watching and waiting for the opportunity to get great equities at outstanding valuations.