Like Captain Kirk and the Kobayashi Maru of Star Trek fame, President Barack Obama faces his own no-win scenario with the budget sequestration due to kick in on Friday.
Created as part of the 2011 debt ceiling deal, and activated by the failure of the congressional supercommittee to find an alternative budget deal, the sequester will slash $1.2 trillion off the federal budget over the next 10 years, split between defense and discretionary spending and without touching entitlements.
It's not Armageddon: The cuts are worth an average of 7% of total spending in these two areas and are a drop in the bucket compared with the $44 trillion Washington is set to spend over the next 10 years.
But it's not insignificant, either: It'll slash at least 0.5% off growth of gross domestic product this year -- at a time when much of the rich world is falling into recession.
Unfortunately, no matter what Obama does -- and, by extension, what Congress does -- it's not going to be good. Here's why, and how investors can prepare.
Anthony Mirhaydari
Take the hit?
For Obama, and indeed for all of us, it doesn't look like this is going to end well. You can see that in the way Washington has gone from looking at ways to avoid or modify the sequester -- by, for instance, giving government agencies the flexibility to make the cuts efficiently -- to figuring out how to blame each other for what's about to happen.
Obama has held campaign-style rallies surrounded by first responders facing job cuts while members of his Cabinet, from transportation to agriculture, have been sounding dire warnings about the consequences of the cuts. Republicans' defense has hinged on the fact that the idea for the sequester came from Obama's team, and that he personally signed off on it, according to reports. (Of course, Congress approved it, too.)
That's because while spending cuts are needed, the sequester goes about them in a pretty stupid way: It freezes the way agencies allocate spending among programs, projects and activities. As a result, planned spending for the overhaul of the USS Abraham Lincoln would be cut by 72% while spending on M1 Abrams tanks would increase 442%.
If the cuts go through, they could push the U.S. economy into an outright recession. While the total size of the sequester is fairly small, its impact is anything but. With quarterly GDP growth bouncing between positive and negative territory lately, it won't take much of a push to unlock all the negative accelerants that deepen new recessions: lost confidence, reduced business spending, lost wages, fewer jobs and lower consumer spending.
In fact, research from the International Monetary Fund suggests that, if the U.S. economy is indeed already in the early stages of a new recession, the drag from the budget sequester could be as large as 1% of GDP. Combined with the ongoing economic hit from the New Year's Day fiscal cliff deal, and the higher taxes that resulted, any further Washington belt-tightening would represent a serious and growing drag on growth.
Moreover, if we do fall into recession, the budget math will deteriorate, since a weaker economy means more spending on things like unemployment benefits combined with lower tax revenues as people lose income and cut spending.
Walk away?
But Obama can't simply work toward postponing or canceling the cuts, either. For one, given that the fiscal cliff deal raised $620 billion in new tax revenues, and given that higher spending (mainly on health care) is the root cause of the terrible long-term budget outlook, it's time to look at trimming the size of government. (Of course, if you support still-higher taxes, those will impact GDP, too.)
Two, the national debt is already approaching the point of no return, with economists warning the U.S. Monetary Policy Forum that we're on the cusp of a self-reinforcing "debt trap" that would be difficult to escape. (Download that Initiative on Global Markets report as a .pdf file.) Separate research has already shown that higher government debt levels are associated with less economic vigor, slower growth and a lower standard of living. (Read the Committee for a Responsible Federal Budget's report.)
And three, it's worth remembering that the sequester is the result of Washington's unwillingness to address the real problem: underfunded entitlement programs that are overpaying, by global standards, for health care that is often mediocre. If we can't find agreement soon, we risk attracting further ire from the credit-rating agencies that unleashed the August 2011 market meltdown after Standard & Poor's cut our AAA rating.
All this represents just the latest chapter of Obama's multi-episode budget battle with Congress. A new budget is needed by March 27 under the threat of a possible government shutdown. If budgets aren't passed by both chambers of Congress by April 15, members of that body would have their paychecks trapped in escrow. And if no deal is found by mid-May, the debt ceiling -- and the risk of a default on the national debt -- would be back in play.
The easy steps have been taken
If there's a silver lining in all this, it's that since the budget fight broke out in 2011 Washington has enacted $2.7 trillion in budget savings over the next 10 years by picking the low-hanging fruit -- steps like rolling back the Bush tax cuts on the wealthy and freezing the pay of government workers.
But that's not enough. According to the Committee for Responsible Federal Budget, we've enacted only a little more than half the minimum deficit reduction needed over the next 10 years to stabilize the debt situation, about one-quarter of the reduction needed through 2040 and only one-sixth the reduction needed through 2080.
Overall, we need an additional $2.4 trillion in deficit reduction to merely stabilize the debt -- the "minimum path" shown above. Otherwise, if we follow the current trajectory, the debt is set to rise from 73% of GDP today to 130% by 2040 and to nearly 350% in 2080. Already, the debt totals nearly $53,000 for every man, woman and child in this country. What's your family's share? Think about it.
Now think about this: Any further reduction requires hard choices. Do we cut the mortgage interest deduction or do we cut food stamps? Do we mothball a few aircraft carriers or do we increase the Medicare eligibility age? Do we further close loopholes or raise taxes on the wealthy, or do we increase out-of-pocket costs for seniors?
Cheating death
Of course, Trekkies know that Kirk beat the Klingons and conquered the no-win Kobayashi Maru simulation by changing the rules of the game. Essentially, he cheated. (Search on Bing to learn more about the Kobayashi Maru test.)
Obama similarly needs to change the playing field. Instead of an either/or dichotomy, we need to find a third way out of this mess. Thankfully, the bipartisan team behind the Committee for a Responsible Federal Budget and Obama's 2010 Fiscal Commission have released a new, balanced road map out of this mess that doesn't blow up the economy or explode the debt. (Read it on the Moment of Truth Project website.)
It calls for lower tax rates but higher tax revenue via reform of deductions and credits. It calls for health care savings via cost sharing and means testing. It trims fat from the budget by tackling farm subsidies along with civilian and military health and retirement programs. And it changes the way the government accounts for inflation.
The hope is that by easing into this balanced plan, instead of accepting the sequester budget hatchet and suffering the political gamesmanship that will surely follow, the economy will be able to keep its head above water.
But Obama's task doesn't stop there. His to-do list includes boosting business confidence, aggressively tackling our infrastructure problems using private capital (see my column "Smarter ways to tap the rich"), and above all, embracing the idea of primum non nocere or "first, do no harm" by putting a moratorium on confidence-bashing ideas like a minimum wage hike, new energy regulation and Obamacare requirements for small businesses.
Unfortunately, given the tone in Washington, I'm not confident this needle will get threaded, so to speak. It certainly won't happen by Friday.
We do have a narrow window in which to find a way out of the overall budget mess. With Japan and Europe succumbing to new recessions, time is short.
Until I see signs that Obama "gets it" and pushes Congress and the country in this new direction, I maintain my bearish outlook on both the markets and the economy in 2013. For investors, that means focusing on defensive, beaten-down assets like Treasury bonds, the U.S. dollar and precious metals -- all of which have started perking up this week on new turmoil in the eurozone.
In my Edge Letter Sample Portfolio, highlights include a near 30% gain in my short against Cliffs Natural Resources (CLF) and a 7% gain in the Direxion Daily 20+ Year Treasury Bull 3X (TMF) exchange-traded fund.
At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column. He has recommended Direxion Daily 20+ Year Treasury 3X ETF to his clients.
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