ETF Trends
ETF Trends

Now that the sequester has hit, many investors are wondering what the $85 billion in federal spending cuts will mean for the US economy and markets. In the very short term, the answer is not much. By the second quarter, however, the story will be different.

Why? The sequester is not the same as the fiscal cliff everyone was worried about earlier this year. If the United States had gone over the fiscal cliff, the full brunt of the tax increases would have hit disposable income, and by extension consumption, immediately.

In contrast, sequester-related spending cuts will not happen immediately, or all at once. Assuming the sequester isn’t reversed during this month’s budget negotiations, the spending cuts will be phased in over coming months. As such, they’ll likely first have an impact on the economy in April and will first become visible in economic data in May. So come the second quarter, here’s what sequester-related economic impacts investors should expect:

  • Increased fiscal drag. As I mentioned last week, fiscal drag from the spending cuts alone is likely to be as high as 0.5% of US gross domestic product. But fiscal drag from the cuts and recent tax hikes combined is likely to be around 2% of 2013 GDP, a large hit for an economy that barely grew by that much last year.
  • A Federal Reserve likely to stay in easing mode until midyear. As the sequester-related cuts represent yet another headwind for the US economy, the already dovish Fed is even more likely to maintain monetary accommodation if the cuts hit as planned. In fact, given all the challenges facing the US consumer, I believe the Fed’s policy will be on hold for at least the first half of the year.

What’s the bottom line for portfolios? The drop in government spending will be a modest negative for the US economy and, to some extent, for stocks as we approach the second half of the year. The spending cuts raise the risk of disappointing second quarter US economic growth and earnings reports, and these could weaken equity gains.

At the same time, continued accommodative monetary policy should help mitigate the effects of a slower economy and be supportive of risky assets. An economy that continues to demonstrate slow but positive growth is also generally supportive of credit products like high yield, which is accessible through the iShares High Yield Corporate Bond Fund (NYSEArca: HYG).

In addition, as gold typically does best when real interest rates are low or negative, gold is likely to benefit from looser-for-longer monetary policy. As such, until the economy starts to accelerate or the Fed moves closer to ending its quantitative easing, I continue to advocate that most investors consider a small strategic allocation to gold.

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.