Have the markets disregarded the potential effects of sequestration? Or is this the first – albeit – awkward step toward spending cuts?

Where we are today
Since the beginning of March, Congress has applied automatic spending cuts (aka sequestration) to 5% of Federal government discretionary spending. Estimated to total $1.2 trillion by 2023, the cuts to discretionary spending were supposed to be so unpalatable when they were proposed that no one thought they would come to pass. In fact, sequestration was designed to compel lawmakers to make the tough choices needed to curb the growth of long-term debt and force a compromise.

Nevertheless, here we are in a sequestration world after more than two years of wrangling and numerous attempts to come up with a credible plan to reduce current spending and long-term debt growth. Starting with the rejection of Obama’s bipartisan deficit cutting commission – or “Simpson Bowles plan”, a failed “grand bargain” by Obama and Boehner, followed by several subpar “Super” committees, sequestration has become the default position until future negotiations devise an alternative framework.

Washington math and some important metrics
1. Since the last debt ceiling crisis in 2011 when Standard & Poor’s threatened to downgrade US debt if lawmakers could not propose a “credible” design for long-term debt reduction, the target long-term debt reduction has been around $4 trillion. $4.4 trillion in cuts over ten years is cited as the amount that would stabilize the debt to government spending ratio at 60% by 2023, down from today’s ratio of 72% but above a long-term US historical average of 50%. (In dollar amounts, current debt is about $16 trillion compared to a government budget of almost $22 trillion.)

2. Sequester cuts apply to discretionary spending, which accounts for less than 40% of the Federal budget. While the cuts may feel draconian to those reduced areas of the budget, $1.2 trillion over ten years is only 27% of the cuts needed to bring down the debt. According to the Congressional Budget Office, spending reductions will be about 8% for defense and 5-6% for non-defense expenditures. See The budget and economic outlook: Fiscal years 2012 to 2013

3. While the recipients of discretionary funding (such as veterans, federal employees and the park service) will feel the cuts the most, the effects of $85 billion in annual spending reductions are blunted by automatic increases in entitlement spending including Social Security and Medicare which coincidentally increases by $85 billion this year over 2012. So in the final analysis, overall government spending is still increasing but at a slower rate and may not be felt more broadly by ordinary Americans in the near-term.

Robust financial markets are focused on an improving economy
The stock market’s advance this year (over 9% for the S&P 500 as of last week) reflects robust corporate profits and improving economic conditions. Consumers are benefiting from increased employment, price appreciation in the housing markets, and growing household net worth.

Against this backdrop, businesses and consumers are less focused on government finances. The impact of federal spending, plus or minus, seems less important now that financial conditions have improved and the Global Financial Crisis has receded.

Does that mean that Washington dramas are no longer important? No, we still have the Continuing Resolution (to fund government operations) and the Debt Ceiling authorization coming up. But for now, the market does not seem to care!