1. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Thought for the Week (240):
Sequestration
Synopsis
Sequestration is a big word that may have an even bigger immediate effect on jobs and the economy.
It involves forcing spending cuts on government projects.
The severity and timing of these cuts will depend on political negotiation.
Whatever happens, stock markets and specific sectors may experience some jitters but we believe there will be little lasting effect.
What is Sequestration? Sequestration means a series of automatic, across-the-board budget cuts to government agencies, totaling $1.2 trillion over 10 years, to be split 50/50 between defense and domestic discretionary government spending. It has been coming for more than a year; with Congress already pushing it back once to March 1, 2013 as part of the year-end fiscal cliff deal. It's all part of an attempt to control the U.S. national debt, which is still growing at an alarming rate and approaching $17 trillion, or 100% of Gross National Product. In other words, the size of our national debt is approximately equal to what the nation produces each year! Although few can argue with the financial need to quickly cut the national debt, sequestration would involve forced cuts applied in an arbitrary manner. More importantly, it will further weaken our already weak economic and employment prospects. More than $500 billion will be cut from the Defense Department and other national security agencies, with the remainder of the savings coming from areas such as national parks, federal courts and housing aid. Last week, White House officials warned of some of the consequences of sequestration, should the $1.2 trillion of cuts kick in as expected on March 1. They include the threat of hundreds of thousands of furloughs across federal agencies, the loss of nutritional assistance for approximately 600,000 women and children, fewer food inspections, disruption of federal education programs, and limitations on access to mental health services. If enacted, it could slash defense spending by 13% and non-defense programs by 9%.
Will Sequestration happen? President Obama has already called for a delay in the automatic sequestration cuts; however, this is just a postponement to allow the cuts to be better organized. Furthermore, when Congress approved the previous sequestration deferment, it imposed $12 billion in cuts spread over 2013 and 2014. As a condition of a new delay, Congress may ask for additional 2013 cuts. If sequestration is to be avoided, both sides of the political debate will have to come to an agreement in a short period of time. President Obama is currently offering a short-term package of cuts together with new tax revenues as a condition for sequestration delay. The mention of “new tax revenues” is guaranteed to alienate
2. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Republicans and cause another round of protracted negotiations. These negotiations could cause a temporary market decline if they become too adversarial. Ultimately, the timing and severity of Sequestration will depend upon the “court of public opinion.” Neither party wants to be blamed for killing jobs and putting our military at risk? Who will back down when called the “party of job destruction?” As always, predicting the consequences of political argument is not something Global looks to participate in. Instead we will analyze and prepare for both outcomes: sequester delay or implementation on or around March 1. Either way, we will be ready.
How will we Play Sequestration? Let’s look at the fundamental logic: The national debt must be cut by a combination of lower spending and increased revenues. Whichever spending reductions are agreed on, defense and non-defense Government programs are directly in the firing line.
Non-Defense: In general, sequestration will be detrimental to domestic GDP growth, but it will also be positive for the country’s financial position as a whole. Companies continue to fare reasonably well and GDP growth looks acceptable. Although the Bureau of Economic Analysis recently announced that our GDP contracted by -0.1% in the fourth quarter of 2012, new data suggests this will soon be revised to the positive. At the time of writing, equity markets just want to go up. Slightly improved economic data causes a sharp upwards move in prices while bad news is dismissed within a day or two. All the charts and investor sentiment seem to be bullish on stocks and investors want in. Or is it possible investors just want out of bonds and cash? We believe any sector with exposure to government funding programs should be avoided. Our general bias towards those U.S. companies with strong overseas revenues should not be greatly affected.
Defense Industry: The opponents of sequestration have cited the Defense sector as its biggest potential casualty. In our opinion, there will be defense cuts and a lot of highly negative public “fear-mongering.” But the reality should not be as severe or immediate as markets currently expect. Defense spending creates real, sustainable jobs together with both direct and indirect revenues from overseas. Its contribution to employment cannot be ignored; just look at some of the potential layoff casualty numbers being touted at the moment: approximately 20,000 job losses at NASA alone. In the 1990s, the “Peace Dividend” associated with the fall of the Berlin Wall caused the stock prices of many defense contractors to fall to bargain levels. Shortly thereafter, prices rebounded as their management responded to the new world order and realigned their businesses to take advantage. Lockheed Martin is a great example of our defense thoughts: 5.2% dividend yield, a low Price to Earnings ratio of around 10 with an excellent balance sheet and revenue diversification. If and when sequestration fears make Lockheed cheaper, we will be looking at acquiring bargain dividend income.