With the deadline having come and gone with no real action from Congress, sequestration is now the reality of the U.S. economy. Originally designed as an unthinkable, unacceptable, avoid-at-all-cost-because-it's-too-horrible-to-contemplate “trick,” in order to force Congress to negotiate and achieve long-term plans for a better balance between spending and revenue generation (taxes), Congress instead decided to think the unthinkable and let it happen.

What It Does
Sequestration is basically surgery by guillotine – blunt, across-the-board cuts in government spending that will total about $85 billion for 2013. Of that, the largest piece will come from defense, where spending will decline by nearly $43 billion or 8%. Domestic discretionary spending will fall about 5% or $29 billion, while Medicare declines 2% ($10 billion) and “other” spending drops $4 billion. After 2013, the cuts continue to the tune of about $110 billion per year, through 2021 (without $90 billion per year coming from discretionary spending).

What makes the sequester of 2013 a little unusual is that the law requires the cuts to be applied more or less evenly to “every program, project and activity.” So while the FDA will see funding go down $206 million, versus nearly $1 billion at NASA and $6.3 billion in military research, those declines are all relative to their respective starting points.

What It Will Do to the Economy
With the flow of money coming out of the government and into the economy suddenly reduced, there will be real effects to the economy. Second quarter GDP is likely to decline by about one to one-and-a-half points, while the full-year impact will likely be similar (due to economists' expectations that GDP growth will improve in the second half of the year).

To a certain extent, the economy has already been preparing and absorbing the impact of this move. Many businesses, large and small, were worried in late 2012 that something like this was going to happen, and they adjusted their spending plans accordingly. A lot of the sluggishness we've seen so far in earnings reports and outlooks has been due in part to the expectation that sequestration was coming. It's also worth noting that the money doesn't vanish overnight, so it isn't as though the economy saw $85 billion in spending disappear in an instant.

The Impact on the Markets – It Depends Where You Look
Ultimately, the cuts tied to the sequester are not going to be cataclysmic or even hugely significant for the market. Strategists at Bank of America (NYSE:BAC) estimated that the net impact of the cuts (taking into account which sectors would be hit, the margins of that revenue and the stock multiples) would be about 1% to the S&P 500 – not exactly a disaster, though more significant on a cumulative basis.

Clearly the biggest risks/impacts will be the defense sector. Unlike negotiated cuts of budget battles past, there won't be as much flexibility to de-prioritize certain kinds of spending in favor of others. That's bad news for companies like Northrop Grumman (NYSE:NOC), Lockheed Martin (NYSE:LMT) and L-3 (NYSE:LLL) that generate 80% or more of their revenue from the government.

There will likewise be impacts seen in the healthcare and life science industries. Spending cuts at the National Institutes of Health and other government agencies will mean lower/fewer grant awards and less cash available for the research equipment sold by companies like Illumina (Nasdaq:ILMN). Likewise, hospitals and healthcare service providers are going to see lower payments coming from the government, forcing them to collect more from patients, push back harder on drug/device suppliers and/or accept lower margins.

On a broader basis, many consumer companies could also see impacts. We have already seen companies like Whole Foods (Nasdaq:WFM) tie lower consumer spending to the higher payroll tax this year, and these incremental spending cuts will ultimately find their way to consumers as well, whether in the form of lower transfer payments, more expensive services or lower earnings (due to furloughs or other moves), etc. Net, there will be less money in the pockets of consumers and less money going toward consumer goods and services. That could be particularly challenging for some industries like for-profit education, but even so-called “inelastic goods” like food may see more substitution to lower-price, lower-margin items.

What Should Investors Do About This?
To a large degree, the market expected something like this to happen, and analysts and investors adjusted their earnings expectations and multiples in response. At this point, then, there is not a lot left for investors to do unless they believe the GDP impact will be worse (larger) than expected and lead to significantly lower growth in the coming years.

This entire situation does offer an argument for why investors should incorporate foreign stocks and bonds into their investment strategy. While the global economy isn't immunized against a decline in U.S. growth, the on-the-ground realities in countries/markets like Mexico, Brazil, Japan and China are not so closely tied to the sequester. Accordingly, the sequester may be a good reminder/opportunity for investors to reexamine their global investment exposures and consider adding more foreign stocks.

It's also worth remembering that there are differences between markets, sectors and individual companies. While General Electric (NYSE:GE) is a large company with a substantial aerospace business, its direct exposure to the sequester is actually quite low. On the other hand, a company like Bristol-Myers Squibb (NYSE:BMY) might be thought of as a “safe” drug stock, but actually relies on government spending more than investors may realize.

Many consumer stocks are trading at relatively high historical valuations at a time when consumer spending is looking quite iffy. On the other hand, tech stocks are looking more reasonably valued as a group and generally have low, manageable exposures to the sequester.

The Bottom Line
Ever since talk of the “fiscal cliff” began back in 2012, there was a part of me that couldn't shake the idea that Congress and the administration wanted this to happen – it was a chance to raise taxes and cut spending while spreading the blame collectively to “Congress” and/or “the government in Washington." That sort of individual deniability is appealing to politicians when it comes to hard decisions.

Perhaps there will yet be a negotiated agreement to tax and spending policy that replaces the sequester. If not, the impact will likely be negative, but not insurmountable – particularly if markets like China and Brazil perk up and kick start international sales growth for American multinationals. In such a situation, investors should do what they always should: investigate individual stocks on their own merits and risks, and seek out a diversified collection of investment assets.

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