Why The Sequester Is Good For Stocks

Markets have soared since federal spending cuts went into effect.

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Who knew political dysfunction could be so lucrative for investors?

In the days leading up to the government spending cuts known as the sequester, politicians in Washington warned of all the bad things that were about to happen. But since March 1, when the cuts went into effect, the stock market has gone nowhere but up and the Dow Jones Industrial Average has repeatedly hit new highs.

[SEE: Political Cartoons on Sequestration]

The stock market, of course, could turn south any day, and the spending cuts could in fact harm the economy as time goes on and the impact builds.

But investors and politicians alike seem to have underestimated the tacit upside of the sequester, which will entail spending cuts totaling about $85 billion in 2013. "The markets feel a little bit better these days because of the sequester," says Mike Thompson, managing director of global markets intelligence at S&P Capital IQ. "It cut through the hyperbole. It turned out it's not that bad."

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Showing investment returns.

The spending cuts affect the stock market in three basic ways. First, they show the private sector is getting closer to standing on its own, even when Washington is harming the economy. In fact, there's been a surprising spate of good news recently about jobs, incomes, business spending and a pickup in manufacturing. The stock market's rousing performance seems to be saying those developments are more important than what's going on in Washington, which wasn't the case a year or two ago.

[READ: How Obama Bungled the Sequester]

The spending cuts also give the Federal Reserve more reason to continue its aggressive easy-money policies. Back in 2008 and 2009, Congress passed fiscal stimulus measures such as temporary tax cuts and increased spending that prevented the recession from being worse. But Congress is now doing the opposite, reining in spending in ways that will slow the recovery that's under way. With fiscal stimulus essentially finished, the Fed's monetary stimulus is the only big government effort to help the economy.

The Fed, admittedly, has been a huge crutch supporting the economy, and it's not clear what would happen if the Fed, too, ended its stimulus measures. But monetary easing has boosted stock values, by encouraging more people to buy stocks in lieu of the puny interest rates they get on highly rated bonds or bank accounts. So anything that extends the Fed's largesse is good for the stock market, at least in the short run.

Finally, the spending cuts actually accomplish something Washington has had great difficulty doing up till now: narrowing the federal deficit. For all the drama, the sequester will only cut federal spending by about two percent per year. But if the cuts stick, they'll add up to $1 trillion during the next decade, which won't solve the whole budget problem but isn't a bad start. In their clumsy, maddening way, politicians in Washington are actually showing more resolve than their counterparts in Europe, which remains mired in debt and stuck in another recession, to boot.

[READ: Obama Loses Credibility on the Sequester]

Thompson believes the spending cuts and the action on the deficit may make U.S. markets a bit more appealing to global investors, and actually draw more foreign capital. "That would drive interest rates down and equities up the right way," he says. "It's ugly, but the reality is we just did something the rest of world has a problem doing."

The sequester is still likely to cause some bumps. The cutbacks could slow GDP growth by half a percentage point or so. That will probably show up in lower corporate earnings, weaker job numbers and other disappointing economic indicators. But that may last for only a few months, and after that, economists are cautiously hopeful that the private-sector economy will gather steam again. The government, it turns out, isn't the only show in town.

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