The Sequester: A Second Quarter Worry

Includes: GLD, HYG, IAU
by: Russ Koesterich, CFA

Now that the sequester has hit, many investors are wondering what the $85 billion in federal spending cuts will mean for the U.S. economy and markets. In the very short term, the answer is not much. By the second quarter, however, the story will be different.

Why? The sequester is not the same as the fiscal cliff everyone was worried about earlier this year. If the United States had gone over the fiscal cliff, the full brunt of the tax increases would have hit disposable income, and by extension, consumption, immediately.

In contrast, sequester-related spending cuts will not happen immediately, or all at once. Assuming the sequester isn’t reversed during this month’s budget negotiations, the spending cuts will be phased in over coming months. As such, they’ll likely first have an impact on the economy in April and will first become visible in economic data in May. So come the second quarter, here’s what sequester-related economic impacts investors should expect:

  • Increased fiscal drag. As I mentioned last week, fiscal drag from the spending cuts alone is likely to be as high as 0.5% of U.S. gross domestic product. But fiscal drag from the cuts and recent tax hikes combined is likely to be around 2% of 2013 GDP, a large hit for an economy that barely grew by that much last year.

  • A Federal Reserve likely to stay in easing mode until midyear. As the sequester-related cuts represent yet another headwind for the U.S. economy, the already dovish Fed is even more likely to maintain monetary accommodation if the cuts hit as planned. In fact, given all the challenges facing the U.S. consumer, I believe the Fed’s policy will be on hold for at least the first half of the year.

What’s the bottom line for portfolios? The drop in government spending will be a modest negative for the U.S. economy and, to some extent, for stocks as we approach the second half of the year. The spending cuts raise the risk of disappointing second quarter U.S. economic growth and earnings reports, and these could weaken equity gains.

At the same time, continued accommodative monetary policy should help mitigate the effects of a slower economy and be supportive of risky assets. An economy that continues to demonstrate slow but positive growth is also generally supportive of credit products like high yield, which is accessible through the iShares High Yield Corporate Bond Fund (NYSEARCA:HYG).

In addition, as gold typically does best when real interest rates are low or negative, gold is likely to benefit from looser-for-longer monetary policy. As such, until the economy starts to accelerate or the Fed moves closer to ending its quantitative easing, I continue to advocate that most investors consider a small strategic allocation to gold.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.

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