Here's When the Sequester Will Start to Hurt

Investors will stay calm until the drama goes off-script. Then watch out.

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Where's the wipeout?

Now that the federal spending cuts known as the sequester are finally in place, isn't mayhem supposed to erupt? After all, President Barack Obama warned of long airport lines, unpaid janitors, furloughed teachers and hundreds of thousands of other lost jobs if the cuts went into effect.

Obama surely knew he was exaggerating to some extent, which is why administration officials are now backtracking and saying they never felt the sequester would causing searing pain on Day 1, or even Day 10. But it will still hurt the economy, they insist, if Congress doesn't do something soon to mitigate $85 billion worth of across-the-board cuts that most government agencies will have to bear this year.

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Economists generally agree that the spending cuts will hurt the economy. The question is how, when, and how deeply. We're now in the process of finding out.

President Barack Obama gestures during a speech about automatic defense budget cuts, Tuesday, Feb. 26, 2013, at Newport News Shipbuilding in Newport News, Va.

The stock market has taken the sequester in stride, with no sharp drops so far. Wall Street investing firms had been advising clients that the sequester would probably happen and stay in place for a few weeks before Congress came up with a better way to reduce government deficits. Markets have held up because the drama is basically going according to script.

The real deadline investors are watching is March 27, when current funding for government operations runs out. If Congress does nothing to authorize further funding, the government will shut down. Many analysts are guessing that new laws to roll back the sequester will be included in negotiations over funding the government at the end of the month. "This upcoming deadline on March 27 could be another hurdle for the financial markets," Gary Thayer, chief macro strategist for Wells Fargo Advisers, wrote in a recent newsletter.

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Some investing firms have been telling their clients that any dip in the stock market triggered by political battles in Washington might be a good buying opportunity because a falling stock market might be the very thing that breaks the logjam in Washington and triggers action on the sequester. That's another factor that has boosted optimism a bit and kept stocks buoyant.

Finally, there's been good news about the housing market, which finally seems to have rebounded for good. Manufacturing is gaining strength, and businesses and consumers are more optimistic than many expected amid all the discouraging headlines from Washington. All of these things are helping absorb the impact of the sequester.

But there still will be an impact, especially if the spending cuts persist into late spring or summer. Most economists agree that the spending cuts would cut GDP growth by a little more than half a percentage point if they remain in force throughout 2013. Forecasting firm Macroeconomic Advisers says the economic slowdown would be most severe during the second quarter, with growth slowing to a sickly one percent or so. That would occur as government contractors and others dependent on federal spending ran out of wiggle room to deal with temporary cutbacks. By May, the drop in spending would start to show up in weaker economic data and downgraded corporate earnings, damaging always-fickle consumer psyches.

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If they stay in force through the end of the year, the cuts could cost the economy about 700,000 jobs, though many of those would probably be phantom jobs that simply never got created, rather than outright layoffs that make headlines. In that way, the effect of the sequester might be amorphous, depressing the economy without a lot of tangible evidence of how it's happening.

So the crunch, characterized by a falling stock market, plunging confidence, a pullback in spending and a general case of the jitters, may come in April or May. It could happen earlier if there's an unexpected shock from someplace else, such as Europe or China. In fact, the Washington follies may make markets more susceptible to a shock, since the sequester shaves the margin for error in the economy.

By later this year, the outlook could be much brighter. Investing firm Piper Jaffray predicts a three-phase "hop, drop and pop" pattern in the stock market, with the hop being the 13 percent gain during the last 15 weeks and the drop being a 5 to 10 percent decline that starts around now. Once that correction has run its course, perhaps by mid summer, Piper Jaffray foresees a frothy bull run that could lead stocks about 12 percent higher than they are now by this time next year. Just watch out for debris along the way.

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