Stocks May Stumble As Sequester Unfolds in Washington

It would be foolish to assume the stock market will shrug off the coming 'sequester.'

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Seriously? You thought the Washington budget follies ended with the fiscal cliff deal?

Gee, that would have been nice. But unfortunately, 2013 is the Year of the Cliff, and the economy will be banging along from precipice to precipice like a bruised cartoon character.

Coming next: The "sequester," a set of automatic spending cuts originally stipulated as part of a 2011 agreement to extend the federal borrowing limit. Those cuts, totaling about $110 billion per year for a decade, were supposed to kick in at the beginning of 2013, but Congress delayed them for two months as part of the fiscal cliff deal. So now they're due to go into effect March 1.

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Almost perfectly on cue, Democrats and Republicans in Washington are beginning the kabuki theater Americans have become so used to. This stale routine involves a false sense of urgency by both sides, legislative proposals meant to score political points that have no chance of passing, and dueling press conferences in which each side blames the others for holding the economy hostage. Democrats in Congress, for instance, recently proposed an alternative to the sequester that includes further tax hikes on millionaires, which Republicans have said they won't even consider this year.

Most economists agree that the sequester is "sudden, harsh and arbitrary," as President Barack Obama said in his State of the Union address, because it would equally cut spending by most agencies without prioritizing what's most important. But if Congress comes up with a better plan, or simply does away with the sequester, it's not likely to happen until the very last minute, in a replication of the fiscal cliff negotiations.

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The conventional wisdom is that Americans have become inured to Washington's dithering, and learned to carry on as if everything will work out okay. Exhibit A is the stock market, which was expected to sink as the fiscal cliff deadline drew near without a deal. Instead, it remained buoyant, then rose by more than six percent during the first five weeks of 2013.

It might be unwise, however, to think that's how the next fiscal cliff will go, or the one after that. The stock market has flatlined in recent days, as investors try to gauge whether a correction is coming. Positive signs include consumer spending, which has held up better than many economists expected following the payroll tax hike that hit everybody's paycheck in January. And consumer confidence seems to be recovering after plunging earlier this year.

But stock-market analysts are starting to worry that investors are becoming too complacent. "It is at times exactly like this when it is necessary to offer a reminder that things can turn bad in a hurry when the market ignores the potential for bad outcomes," Patrick O'Hare of Briefing.com recently wrote.

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Economists are guessing that somewhere between half and all of the spending cuts stipulated in the sequester will take effect starting in March. If all of the spending cuts kick in, it would cut GDP by about 0.7 percentage points. Since the economy is only expected to grow by about two percent this year, that would be a meaningful cutback, especially since it comes after another hit to GDP from the tax hikes at the start of the year. If only half of the sequester kicks in, it will still sting.

The sequester deadline will be followed by the expiration of the government's funding provision a few weeks later, which could trigger a federal shutdown and more incremental damage to the economy if there's another budget battle. Then, over the summer, Washington will hit its borrowing limit again, forcing another possible showdown. There could be other tense decision points if Congress delays action on any of these matters, as it often does.

In his State of the Union address, Obama declared that "the greatest nation on Earth cannot keep conducting its business by drifting from one manufactured crisis to the next." Yet that's exactly what seems likely to happen for the foreseeable future. If Americans are able to shrug off every one of these faux crises, the U.S. economy will turn out to be far more resilient than it looks right now.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.