…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 US had gone over that cliff, the full brunt of the tax increases would have hit disposable income immediately and, by extension, consumption. In contrast, sequester-related spending cuts will not happen immediately, or all at once.
The hit comes in the second quarter
Assuming the sequester is not reversed during March’s budget negotiations, the spending cuts will be phased in over the coming months. As such, they are likely to make their initial impact on the economy in April, becoming visible in the economic data in May.
If the cuts are not reversed, we see the sequestration as a modest negative for the economy and, to some extent, stocks over the next three to six months. In aggregate, the sequester represents roughly 0.5% of GDP, which is in addition to the previous fiscal drag of roughly 1.5%.
Given the current economic environment, the real impact may be even higher. There is evidence that spending cuts and tax increases have a larger impact on growth when interest rates are stuck at zero.
The bottom line? We believe the sequester is not likely to have a big immediate economic impact, but the spending cuts do raise the risk of economic and earnings disappointments as we get into the second quarter.
Keeping the Fed in easing mode
One implication of the sequester is that it will probably keep an already dovish Fed in easing mode, at least for the first half of the year. With the sequester representing yet another headwind, the Fed is even more likely to take its time before withdrawing monetary accommodation.
This was evident in Chairman Ben Bernanke’s recent remarks. In delivering his semi-annual monetary policy outlook to Congress last week, the absence of any real discussion of a Fed exit strategy was notable. Interestingly, this reassured investors, who were growing increasingly nervous over the possibility of an early end to QE.
The fact that the Fed is likely to maintain its asset purchase program, at least through the first half of the year, will help mitigate the effects of a slower economy and is supportive of risky assets.
Investors take note: gold and high yield should benefit
Of late, gold prices have been falling, largely due to investor nervousness over the longevity of QE. However, earlier this week, following Bernanke’s very dovish testimony, gold rallied more than 1%. To the extent monetary policy remains accommodative, it is likely to benefit gold. The reason is that monetary policy – as measured by real interest rates – is a key driver of gold’s performance. Gold typically does best when real (inflation-adjusted) rates are low or negative, as they are today, as this removes the opportunity cost of holding gold.
Looser-for-longer monetary policy supports this environment and suggests investors should maintain some small, strategic allocation to gold. What would change our view? Should the economy start to accelerate and the Fed signal an end to QE, that would suggest trimming or removing the allocation to gold. But given that the sequester and the challenges still facing the consumer are keeping the economy in slow-growth mode, we believe the Fed will be on hold for at least the first half of the year, which may help bolster gold prices.
Another asset class we believe will benefit from continued Fed accommodation and slow but positive economic growth is high yield fixed income. Easy monetary policy and low rates allows companies with lower credit ratings to refinance their debt at favourable levels, leading to continued low default rates. Were the environment to shift toward rising rates, that would change, but we don’t see that in the near term.
