Does the Sequester Have Any Impact on Your Portfolio?

by Jason Jenkins

It's amazing how many debacles our government can create.

There's nothing about the phenomenon known as a "sequester" in any of our political history books because it's not supposed to be the normal way in which government works.

So how did we find ourselves in this situation? What we all know now as "The Sequester" came about as part of the Budget Control Act of 2011. The act was better known as "The Debt Ceiling Compromise."

The legislation initially stipulated that the sequester cuts would take effect January 1, 2013. Remember, this was a part of the perfect storm – along with the expiration of the Bush-era and the payroll tax cuts – affectionately known as "The Fiscal Cliff."

The result of this double-edged sword would have been a massive fiscal contraction that most likely would have been a catalyst for another recession.

The combination of tax increases and spending cuts was supposed to be a deterrent against partisan bickering on the Hill. The fiscal cliff option was so distasteful to both sides that no one considered either side would let it get this far. It was expected that the Joint Select Committee on Deficit Reduction – or as the media deemed them, "The Supercommittee" – would get a deal done to trim $1.5 trillion over the next 10 years. If the deal was done and passed by Congress December 23, 2011, most Americans would have never heard of the term "sequester."

As we know, a compromise was reached to avert the cliff. However, the sequester was pushed back in that deal to March 1, 2013.

That date has come and gone…

Keeping An Eye on The Second Quarter

So where will these cuts come from? They will be split down the middle between domestic spending and defense programs. Half of the cuts will be directed to defense discretionary spending for things like buying weapons and base operations. The rest will affect mandatory and discretionary spending on the domestic side.

Now that the deadline has come and gone, a lot of people in the investment world are wondering what effect $85 billion in Federal spending cuts will have on the broader economy and our markets. Well, there was never going to be an immediate hit by the sequester alone.

The whole "Chicken Little, the sky is falling routine" did have some merit when we were discussing the fiscal cliff because we would have felt the extra tax burden from day one.

An attack on disposable spending would have created major repercussions on consumption at the beginning of the year.

The sequester will take some time to be implemented and felt. Spending cuts by Federal and local governments will be phased in over time, and you probably won't see their effects till next quarter. The impact could be seen around the latter Spring. Here's what you could see:

  • Here's a term that many people could start hearing about in the second quarter. Fiscal drag is an economic term that describes the situation when the Federal government's net fiscal position – defined as government spending less any taxation – does not meet the net savings goals of the private economy. In everyday speak, fiscal drag is a burden on the economy because of a lack of government spending or too much government taxation. Excessive taxation slows down the demand for goods and services, which results in fiscal drag. If all things stay the same, we may see a drag in the economy come May or June.

  • Also, if things remain as they are presently, don't expect any change in Federal Reserve policy. With forecasts of more job losses due to the sequester, the Fed will probably make sure its easing policies will stand pat until our economy can deal with this new challenge.

As it stands right now, the sequester may have some negative impact on our economy and maybe some earnings reports latter in the year. But Fed action will help support equity markets. I think in the end, your investing approach should not change.

In fact, research supports this advice.

Staying the Course

For those investors who have a short-term focus or would categorize themselves as speculative, there could be some hard times generating profits come the second quarter of 2013. However, for those with skin in the game for the long term – attempting to build wealth – the sequester is just the next blip in the market.

Here's some interesting research. According to Eric Nelson, co-founder of ServoWealth Management:

"But as we look back on the short and intermediate returns of a balanced, diversified asset class portfolio (60% stocks, 40% bonds) in response to the major crises we've endured in the last few decades, we find these declines tend to reverse course quickly as higher expected returns turn into higher realized returns."

The numbers speak for themselves:

Table: A Balanced Portfolio's Response to Crisis (Total Returns)*

CRISIS 1 Yr Later 3 Yrs Later 5 Yrs Later
Black Monday (10/87) +2.0% +16.2% +61.0%
Savings & Loan (8/89) +4.8% +27.1% +68.8%
Asian Contagion (8/98) +11.2% +28.1% +45.1%
Tech Collapse (3/00) +11.4% +9.7% +73.9%
Terrorist Attacks (9/01) -1.6% +37.5% +75.4%
Lehman Bankruptcy (9/08) +1.2% +22.8% +37.5% (1)
US Debt Downgrade (8/11) +5.6% +11.6% (2)  n/a
AVERAGE +4.9% +21.9% +60.3%

Over the past 26 years, only after 9/11 did we have a negative average portfolio return 12 months after a crisis. Also, notice the significant three- and five-year returns. Even though history is no future guarantee of returns, the trend is obvious.

So what can I tell you? The long-term wealth building investors should just worry about the foundation of asset allocation, time horizon and risk tolerance. Something we here at Investment U have been preaching for a long time.

Good Investing,

Jason

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