Wall Street shrugs off 'sequester': Why is it ignoring Washington this time?

Sweeping government spending cuts are set to go into effect by the end of Friday, a move some in the government have called calamitous – and yet financial markets appear to be unfazed by the “sequester.”

The across-the-board cuts have inspired doom-and-gloom scenarios, with government officials warning it would result in airport delays, furloughs in the Pentagon, reduced border security, lost access to Head Start for almost 5,000 low-income children – and potentially more forest fires and chicken shortages.

Previous fiscal showdowns in Washington – like the "fiscal cliff" standoff late last year – left investors jittery and the stock market wobbling. This time, analysts say, the market is ignoring Washington’s antics.

“The market has completely shrugged it off,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “People have barely batted an eyelash.” 

Indeed, Wall Street indexes closed higher on Friday: The Dow Jones Industrial Average rose by 0.25 percent to close at 14089.66; Nasdaq rose 0.30 percent to close at 3169.74; and the Standard & Poor’s 500 rose by 0.23 percent to close at 1518.21.

And the stock market is at a five-year high, with the three main indexes near record territory. The Dow has recovered all the losses it incurred during the financial crisis and is now near its pre-recession peak. Following the dotcom bust of 2001, the Nasdaq is trading at an all-time high. And the S&P 500 has been rising steadily since the fiscal cliff standoff, now at its highest levels since 2008.

If the spending cuts go through as planned, the market will certainly feel the blow, but for now, it’s business as usual on Wall Street.

Why is the market continuing to improve despite the prospect of weaker growth as a result of the sequester? Analysts count a number of reasons behind the relative stability of the market, from strong corporate earnings and a rebounding housing sector, to an investment community that’s had time to adjust to the impending cuts and that continues to expect some sort of deal to mitigate the sequester’s impact.

“The market has in large part moved on,” says Art Hogan, a managing partner at Lazard Capital Markets. “By that I mean, as you look at the fiscal cliff, how much angst was in the market, we’re not seeing anything that resembles that whatsoever.”

Here’s why:

Wall Street is buoyed by an improving economy.

Broadly speaking, the economy is continuing a slow but steady recovery, and Wall Street has reacted accordingly, assuming that growth in strong sectors of the economy will largely offset the impact of spending cuts.

“We have what appears to be an improving economic picture,” Mr. Hogan says. “When you juxtapose better economic data ... against the potential impact of cuts in government spending, investors are more attuned to the stronger economy. That may well outweigh the potential impact of cuts.”

Government spending cuts, adds Morgan Housel, a macroeconomic analyst with the Motley Fool, an online financial education website, are just one part of the stock-market equation.

“The market looks at corporate America in its totality, and right now the rebound in housing and energy are likely to offset any damage from the sequester,” Mr. Housel says.

Furthermore, the economy has improved in part because the Federal Reserve has kept interest rates low to encourage growth. Low interest rates mean low yields on bonds, which in turn drive investors toward stocks, driving the market higher.

The stock market is a reflection of the health of corporate America.

As Washington bickers, corporations are enjoying record profits, strong balance sheets, and plenty of liquidity, so it’s no wonder the market is strong.

“We have record corporate profits and record dividends, so it's not surprising that stocks are doing well,” Housel says. “So even though we have high unemployment and political dysfunction, corporations have never been more profitable. And over the long run, profits are what drives the market.”

And it seems investors are finally taking notice. With weak returns on bonds, investors are returning to stocks, further bolstering the market. 

“Bonds and cash have really run their course,” Housel says. “Investors are realizing that if they want to earn a return on their money, they need to come out of their bunkers and participate in the stock market.”

Financial markets have had time to adjust.

With news of the sequester dominating headlines for weeks, investors have had plenty of time to assess the potential impact of cuts long before they go into effect. In other words, the rug isn’t being pulled out from under the economy overnight. 

“Having known this was coming, some of us may well be prepared,” says Hogan of Lazard Capital Markets. 

More important, the impact of the sequester will be gradual, not immediate, with spending cuts and furloughs taking place over a period of time. For example, legislation dictates that most federal employees are given a 30-day notification before furloughs are enacted. Cuts are also likely to be staggered to minimize their impact.

The gradual rolling out of cuts may well be a boon to the market, mitigating the blow for investors.

Investors are still counting on a deal.

That gradual pace of cuts also gives lawmakers more time to hammer out some sort of deal that could mitigate or even overturn the cuts – a development many in Wall Street are counting on, analysts say. 

“Neither party wants the sequester cuts to take place in the current form, so I don't think you can rule out the cuts being overturned in the coming weeks or months,” says Housel of the Motley Fool.

“Investors are actually making the assumption that some other type of arrangement will be made ... some type of deal ... that softens the blow or changes the places where cuts are made,” Hogan adds.

In fact, as inflexible as the cuts appear, “policymakers have a variety of tools at their disposal that would allow them to delay or ameliorate the full impact of the budget tightening,” CBS News reports, adding that congressional Republicans are working on legislation that would give the government greater latitude in allocating cuts, potentially redirecting them toward less crucial functions within an agency.

In the grand scheme of things, the cuts are relatively small.

Deal or no deal, the cuts actually represent a relatively small percentage of federal spending. Too small, some analysts say, to do serious damage to the economy – or the stock market.

Consider this: This year’s entire slate of spending cuts – about $85 billion – are expected to shave only about half a percentage point off GDP growth.

The Federal Reserve, says Mr. Chandler of Brown Brothers Harriman, is currently buying about $85 billion worth of Treasury bonds and mortgage-backed securities every month.

“On the big scale of things, it’s not so much,” he says.

Wall Street is ignoring Washington’s drama.

Following the frenzy of the fiscal-cliff standoff late last year, Wall Street, like parents accustomed to their teen’s dramatics, is ignoring Washington’s antics.

“We're just continuing to desensitize,” Jim Paulsen, chief market strategist at Wells Capital Management, told CNBC. “How many times are you going to sell out on some kind of Armageddon story, only to watch the darn thing go to new highs?”

In other words, Housel says, Wall Street is Washington-wary.

“We've learned over the years to not pay too much attention to Washington battles,” he says.