Asset management

11 March 2013

Economist Insights Sequestionable
Automatic spending cuts negotiated by the US Congress in 2011 have kicked in. Known as the sequester, the idea was that the cuts would be so unwelcome that they would force an agreement to avoid them. But that idea failed and the US is seeing more fiscal tightening this year. The economic impact may not be as big as some had feared – economic data for the US continues to come in stronger than expected, and the market does not seem that bothered. This may also be an example of risk habituation – the more that markets are exposed to political uncertainty, the less they worry about it. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

It is rare for politicians to admit that they are basically inept, but that is pretty much what the US Congress did in the summer of 2011. Following their failure to agree on a proper fiscal deal, opposing politicians agreed on a set of automatic cuts that would be so painful for both sides that surely they would want to avoid them. Thus was born the ‘sequester’: maybe not mutually assured destruction, but mutually assured discomfort at least. The sequester includes harsh cuts to defence spending that the Republicans hate, and cuts to Medicare and benefits that the Democrats hate. The idea was that none of the politicians would be stupid enough to allow it to happen. It has happened. Draw your own conclusions from what that means, but do not be too hasty. Many politicians had clearly started to question the sequester’s impact on the economy. After all, the sequester is actually pretty small compared to the fiscal cliff or the risk of not passing another continuing resolution – or proper budget (see chart 1). For some politicians, Democrats openly and Republicans secretly, the sequester may have been the only means of finally cutting back on defence spending. The political calculus also affected politicians’ attitudes to the sequester. Some Republicans may see the sequester as their best bargaining chip – after all, they can always negotiate offsetting increases to spending in the Budget negotiations over the next month or so. President Barack Obama has publicly lamented the impact of the sequester, but has gleefully been highlighting these impacts at the same time in

the hopes that voters will blame the Republicans. Perhaps this explains why there was none of the frantic activity to avert the crisis that we saw before the fiscal cliff on 1 January.
Chart 1: Fiscal impacts Fiscal tightening from fiscal events as percent of GDP, fiscal years (runs to September of year shown) 2.5 2.0 1.5 1.0 0.5 0.0 2013 Baseline tightening Fiscal cliff Sequester Potential fiscal cliff One month of shut-down

2014 – 2022

Source: Congressional Budget Office, UBS Global Asset Management Note: The continuing resolution and the debt ceiling are represented by the impact of one month of government shut-down, as the overall impact would depend upon the duration of the resulting shut-down.

Putting the political impacts aside, what about the economic effect of the sequester? That really depends upon what you think the multiplier for government spending is. In other words, how effective you think government tax and spending is at supporting or slowing growth. The conventional assumption was always that the fiscal multiplier was less than 1, so that cutting spending by 1% of GDP would actually

slow the economy by less than 1%. Recent research from the IMF cast doubt on this assumption (see Economist Insights, 15 October 2012), suggesting that the multiplier could be a lot higher, especially when the economy is operating below potential. While this argues that the economic impact of the sequester could be larger than its relatively small size would suggest, there are good reasons to think the impact may be less noticeable. Firstly, everybody knew that austerity was coming in 2013 and hence they probably adjusted early. This sits well with the soft pace of growth in 2012. Secondly, the economic data for the US continues to come in stronger than the market expected – hardly indicative of an economy that is being dragged down by the larger fiscal tightening that has already come into force. Thirdly, the market just does not seem that bothered by the sequester.

Risk habituation is not restricted to the markets – it may also be affecting politicians. Fiscal brinkmanship has been the norm since mid-2011, so perhaps politicians no longer consider impending fiscal disaster as potentially disastrous. Politicians may also be reacting to the markets. As the sequester loomed but equities barely sold off, politicians may have thought that perhaps it would not make much difference to let the cuts happen. The market reaction suggests that the politicians were right; the hope is now that both markets and politicians are right about the final economic reaction.

Chart 2: Non-defensive DataStream US Equity Market Index and Defense Sector Index, rebased to 1 October 2012 = 100 110 105 100 95 90 85 Oct-12 Nov-12 DS US Defense Index
Source: DataStream

Fiscal cliff

Sequester

Sequiescent So politicians failed to stop a fiscal contraction that almost nobody said they wanted, and the S&P 500 reacted by rallying over 1.5% over the subsequent three days. Investors clearly do not think that the sequester will have a discernible impact on the businesses they are buying shares in. The market may be blasé about the overall economic impact, but it knew that there would be losers from the sequester. Defence-related companies have severely underperformed the broader equity market since late January when it became clear that the sequester could in fact happen (see chart 2). Since the military was unlikely to fire lots of employees on the back of a budget cut that could turn out to be temporary, contractors were always going to be the ones to suffer. The market’s insouciance is a prime example of ‘risk habituation’ (see Economist Insights, 14 January 2013). The more that markets are exposed to political uncertainty, the less they worry about it. In part this is because markets were already positioned for weakness after years of sub-par recovery, and in part because some of the uncertainty is actually going away. After all, investors now know that the fiscal cliff was averted, even if there was no grand solution that removed all the remaining uncertainty.

Dec-12 Jan-13 Feb-13 DS US Equity Market Index

Mar-13

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