The Great Yawn of 2013

Contrary to widespread predications, the sun rose this morning and the world did not end. The overnight reduction in our defense spending did not prompt expansionist, vengeful Mexicans to try to retake California and Texas, kicking soccer balls all the way. Cigar chomping Cuban communists did not capture Florida. Hockey stick brandishing Canadians failed to even launch another punitive military excursion into upstate New York.

The more pedestrian predications failed to materialize, as well. Lines at airports were shorter than usual, as so many had delayed travel on the first day of The Great Sequestration. Planes did not fall out of the sky. It turns out that air traffic controllers are exempt from cuts, as are a lot of other key government services. Schools opened. Over the weekend, we learned that the actual disbursement of federal subsidies doesn’t slow for another six months.

Checking the San Francisco papers over the weekend, it looks like we’ll lose a million dollars here and two million there. In a state with a GDP of $2.7 trillion it doesn’t amount to spare pennies found under the sofa cushions by the cleaning lady. Virtually all military bases in the Bay Area were closed during the nineties, as they were so old and decrepit. Many of the rotting Quonset huts were hastily erected in WWII, and one red brick naval facility dated back 150 years. Even in conservative San Diego, the last bastion of defense spending in the Golden State, the pink slips going out are not even a blip on the radar.

California, which accounts for 15% of America’s population and 17% of the GDP, is remarkably immune from anything that happens in Washington. That’s because when it became a state in 1849, it took three months to get here by sailing ship around Cape Horn, or six months by wagon along the Santa Fe Trail. The distances were so great, the ties of dependence were never established, unlike in the East. But the wealth did pour out. The Union Army won the Civil War financed by California gold.

The financial markets crash didn’t crash either. The Dow average closed the day up 38 at 14,127. That is a mere handful of points off of a five-year high, and only 37 points short of the all time high of 14,164 set on October 9, 2007. If anything, the markets are crashing upwards. What gives?

This is turning out to be one of the “emperor has no clothes” moments in financial history. The $84 billion sequestration amounts to only 32 basis points of US GDP, 2.3% of the total federal budget for 2013, and 8.4% of the budget deficit. That means $916 billion in budget deficit remains to stimulate the economy. In other words, it might cancel out the positive effect of Apple’s iPhone 5 launch on economic growth.

There are some parts of the country that will certainly feel the pain from sequestration. But these are in parts of the country that most Americans don’t care about. The worst hit will be in Washington DC itself, or within lobbyist lunching distance of the nations capital. That’s why defense spending accounts for 20% of state GDP in Virginia and Maryland, but only 2% in New York.

Let’s look at the positive effect of the sequester on the financial markets. The budget deficit has fallen substantially, arresting the fall of the Treasury bond market. We have seen the first substantial cuts in defense spending since the Soviet Union collapsed 20 years ago, enabling the  "peace dividend".

The sequestration does have the effect of cancelling out some of the stimulus provided by the Federal Reserve’s Ben Bernanke. Ben will simply respond by making up the difference through expanding quantitative easing and extending the zero interest rate policy. This is what financial markets see when they refuse to sell off.

I should add that my prescient forecast that sequestration would amount to a big nothing has been fabulous for the performance of my model portfolio, which is up 29% so far in 2013. In fact, it looks like this sequester is going so well, we should plan on having a second one.