The Pavlovian sequester response?

Has the equity market been conditioned, like Pavlov's dogs, to expect a last minute sequestration deal? Why has there been no negative market reaction when it was reported (via NBC) that Obama would meet Congressional leaders on Friday, after the sequester deadline [emphasis added]?

After weeks of argument over the sequester, bipartisan congressional leaders will meet with the president at the White House on Friday -- the same day that automatic federal spending cuts are scheduled to go into effect.

President Barack Obama will meet with House Speaker John Boehner, House Minority Leader Nancy Pelosi, Senate Majority Leader Harry Reid and Senate Minority Leader Mitch McConnell to discuss the across-the-board budget reductions to federal agencies, aides told NBC News.

Republicans were quick to question why the White House would schedule the meeting only on the final day of the belabored back-and-forth over the cuts.

"If the President is serious about stopping the sequester, why did he schedule a meeting on Tuesday for Friday when the sequester hits at midnight on Thursday?" a Republican aide told NBC. "Either someone needs to buy the White House a calendar, or this is just a - belated - farce. They ought to at least pretend to try."

I don't need to go on and on about the deflationary effects of immediate and overnight cuts in government spending. Here is Fed chairman Ben Bernanke on the likely effects of sequestration (via The Bondad Blog):

However, a substantial portion of the recent progress in lowering the deficit has been concentrated in near-term budget changes, which, taken together, could create a significant headwind for the economic recovery. The CBO estimates that deficit-reduction policies in current law will slow the pace of real GDP growth by about 1-1/2 percentage points this year, relative to what it would have been otherwise. A significant portion of this effect is related to the automatic spending sequestration that is scheduled to begin on March 1, which, according to the CBO's estimates, will contribute about 0.6 percentage point to the fiscal drag on economic growth this year. Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant. Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run for any given set of fiscal actions.

The market's reaction
I have been watching Defense and Aerospace stocks, as represented by ITA and PPA, as a barometer of market sentiment about the effects of sequestration. As you can see by the relative performance of ITA against the market, ITA has been in a minor relative uptrend for most of February and has beaten the market in the last couple of days.

The relative performance of PPA also shows a similar pattern of relative outperformance for February and this week.

So let me get this straight. President Obama is meeting with senior Congressional leaders to discuss sequestration on Friday, after the deadline has passed. Meanwhile, the Dow rallies and defense stocks, which are highly sensitive to government spending, are outperforming the market.

Is the market just conditioned to getting a last minute deal, just like what we saw during the 2011 debt ceiling impasse, or endless eurozone summits over Greece in the same year?

What happens to equity prices if the cavalry doesn't arrive?




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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