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Thursday, February 28, 2013

By now, you have likely heard of this “sequester” that goes into effect on March 1, 2013. According to Merriam-Webster dictionary, sequestration means 1: the act of sequestering: the state of being sequestered <a jury in sequestration> 2a: a legal writ authorizing a sheriff or commissioner to take into custody the property of a defendant who is in contempt until the orders of a court are complied with b: a deposit whereby a neutral depositary agrees to hold property in litigation and to restore it to the party to whom it is adjudged to belong.

Leave it to US politicians to use this term instead of describing the situation as it is – federal spending cuts!

An article appeared February 23, 2013, on page A4 in the U.S. edition of The Wall Street Journal (WSJ), with the headline: How Federal Spending Would Be Cut Under the Sequester, which was a Q&A on the topic of sequestration. We recommend interested parties read the article for details, but we’ll provide an overview for your reference.

How did this come into being? The sequestration came about in 2011 when the US was pushing up against the debt limit at that time. Republicans wanted spending cuts as part of approving an increase of the federal debt limit. Well, this happened but both parties knew more deficit reduction would be needed to garner support from the Republicans. So the White House (i.e. President Obama’s camp) proposed forming a “supercommittee” (another Washington D.C term) comprised of members from both political parties that would work together (yeah, right!) to further reduce the deficit by $1.2 trillion OR this “sequester” would kick in if no compromise was reached. The sequester was thought to be so drastic that the parties would absolutely come to agreement so as not to face the consequences. The supercommittee had adequate time to work things out, but guess what – surprise – no compromise – and here we are! Across the board cuts!

What will happen immediately? Likely, not much. The various agencies will have to budget for spending cuts, which will take a bit of time. However, the message to viewers of mainstream media is that it will be bad! First responders not there to respond, long lines at security checkpoints in airports, lack of air traffic controllers, cuts to educational programs, and on and on.

Tell me more about the spending cuts. Agencies will likely start cutting spending by reducing travel and not filling vacant positions followed by furloughing workers. The cuts are spread about to over 1,000 federal programs and tens of thousands of subprograms and projects. The three broad categories affected are defense spending, nondefense spending, and Medicare. The agencies will apportion the cuts as they see fit.
How much spending cut are we talking about? The number to start with is $85 billion. This is 2.4% of the federal budget, according to the WSJ article. Depending on the agency, cuts range from 5% to 13% of their respective budget.

So now what? Well, the financial markets haven’t shown much concern yet. Here we are trading near all-time highs. Yes the Federal Reserve continues to provide liquidity and is maintaining an ultra-low rate posture, which is helping risky assets. Earnings from S&P 500 constituents were good this season. We will likely hear posturing from both sides – Republicans and Democrats – about spending cuts and more tax increases. But no matter the side of the aisle one associates, it seems reasonable that steps towards a balanced budget have to be good for the long-term health of our economy. One only has to gaze at our cousins across the pond to see what excessive debt can do to economies. Perhaps if the cuts were more measured and focused it would be more sensible and keep higher priority programs funded, but given Washington’s recent track record, one probably shouldn’t count on much first class governance coming from our disjointed political system.

Good luck out there!

The remarks and observations stated here represent the views and opinions of Fund Architects, LLC, and are not intended to be construed as investment advice. Fund Architects is not responsible for any actions taken as a result of these comments. No form of compensation is received for the contents of this blog.