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Recent months have brought some indications that the storm clouds over the U.S. economy are beginning to clear. Manufacturing activity is picking up again, earnings reports have been generally impressive, and consumer spending and confidence have shown signs of a pulse. Though major indexes have reached (or nearly reached) pre-recession levels, there are still lingering concerns. Job creation, believed by many economists to be an indication of a sustainable recovery, has been non-existent. And though we have ousted the sub-prime mortgage issues and strengthened our dollar to some extent, we are still left with one other major issue: debt–over $14 trillion of it to be precise. To put that in perspective, a stack of $100 dollar bills totaling $1 trillion would stand roughly 740 miles high, meaning our current debt stack would be roughly 10,360 miles tall.

The government deficit has rapidly increased over the past decade, and is quickly becoming the single biggest concern for investors and government officials alike. Now, President Barack Obama has released his budget plan for the fiscal year 2012. The plan will aim to spend $3.73 trillion throughout the course of the year, in an effort to lower our deficit over the next decade. The aim of the budget plan is to make heavy allocations in 2012, and cut spending across the board for the rest of the decade, slowly lowering our annual deficit as the years go on and eventually lowering the total by $1.1 trillion dollars. As with any budget proposal, the plan was met with heavy opposition, as the biggest critics criticized the report for lacking specifics on how exactly it will be implemented, as well as lofty growth projections [see also.

Specific Targets

The proposed plan will boost research on alternative energy such as solar and wind, while also increasing spending on education. A substantial portion of the budget will be focused on green technologies, and improving our air and water quality. “Mr. Obama’s budget would spend $584 million to support research and innovation into new and emerging environmental sciences, including a $24.7 million increase in grants tied to clean air and water,” write Janet Hook and Damian Paletta. The budget will also increase spending on Medicare and health services for veterans wounded in recent wars.

But what will garner the most attention will be the tough cuts the government has proposed. This will come in the form of less spending on sectors such as defense, and slowly winding down wars in Afghanistan and Iraq. Due to the massive size of the proposed budget, it will likely be a major mover for the market, and ETFs alike. Below, we outline three major budget cut proposals, and how they will directly impact ETFs in the future.

Oil

The budget will bring higher taxes to oil and natural-gas companies through the elimination of “tax preferences”, and will also feature a $500 million investment “to restructure the federal agency that regulates offshore drilling” in response to last year’s Deepwater Horizon Spill. Higher taxes will lead to a squeeze in profits, and with offshore drilling regulations ramping up in the U.S., it may be difficult for many major oil firms to gain permits to drill and access oil vital to their revenue streams.

SPDR S&P Oil & Gas Exploration & Production Fund (NYSEARCA:XOP): This ETF tracks an index which represents the oil and gas exploration and production sub-industry portion of the S&P Total Markets Index. The all-U.S. fund is home to many big names in oil/gas exploration, such as Chesapeake Energy (3.1%), Devon Energy (2.9%), and Valero Energy (2.8%). The fund invests in approximately 38 securities which focus on the medium and large cap sectors of the market. XOP is up over 10% in 2011, but it may see a major hit if the tax breaks for oil firms are eliminated and offshore drilling requirements are steepened.

Water

Though Obama plans on improving water quality, (with $24.7 million increase in grants tied to researching clean water solutions) his budget will trim nearly $1 billion from the the Environmental Protection Agency’s Clean Water and Drinking Water State Revolving Funds, a 27% cut from 2010 levels. These funds subsidized both state and local water/sewage project, and cutting these subsidies could lead to higher water prices for consumers. A lack of subsidies will also take away incentives for new water infrastructure, and could create a major bottleneck in the industry.

PowerShares Water Resource Portfolio Fund (NYSEARCA:PHO): This fund measures an index that consists of companies that focus on the provision of potable water, the treatment of water, and the technology and services that are directly related to water consumption. The fund holds nearly all of its assets in U.S.-based firms, the majority of which are either small or medium cap companies. Investors in this ETF should carefully monitor what happens to government subsidies in the water sector, as they will directly weigh on this fund. Specifically, investors need to pay attention to any proposals which could make it more difficult for local areas to raise the necessary capital to improve their water related infrastructure, as many of the components of PHO thrive on these types of projects.

Biotech

Another proposal in the budget would “hasten the availability of generic biologic drugs by reducing the market exclusivity period for brand biologics to seven years from 12 years” notes Brent Kendall. Kendall goes on to point out that biologic drugs are differ from traditional drugs in that “biologic drugs are complex and expensive medicines derived from proteins manufactured in living cells. Traditional drugs are made by mixing chemicals”. Along with a decrease in patent life, another proposal would eliminate controversial settlements where brand-name pharma firms pay generic competitors to halt patent challenges. This combination could prove deadly for biotech ETFs, as patent lives may be drastically reduced, and competition will ramp up on numerous drugs, potentially slashing profits for many firms.

iShares Nasdaq Biotechnology Fund (NASDAQ:IBB): IBB seeks to replicate the performance of the NASDAQ Biotechnology Index, which contains NASDAQ listed companies classified as either biotechnology or pharmaceuticals companies. Major holdings in this ETF include Gilead Sciences (5.1%), Alexion Pharmaceuticals (3.8%), and Genzyme Corporation (3.2%). With the fund holding roughly 90% of its assets in U.S. firms, Obama’s budget could have significant consequences for the biotech companies that make up this ETF. A shorter patent life and the end of patent settlements could sink these companies and ETF alike, potentially marking a tough road ahead for these companies should President Obama’s budget pass with this stipulation intact.

Photo courtesy of Ari Levinson.

Disclosure: No positions at time of writing.

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Source: Warning: Obama's $3.73 Trillion Budget Could Sink These 3 ETFs