Sequestration Could Decimate Consumer, Defense Stocks

With the fiscal cliff having been averted, “budget sequestration” has risen to prominence as the next Washington-made market threat. Investors have legitimate concerns that mandatory, across-the-board cuts in government spending will send the economy into recession with areas such as retail and defense being particularly hard hit. Should the sequestration go through, the U.S. Federal Government's budget will be slashed across the board. Agency budgets -- both Defense and non-Defense -- will be uniformly reduced. From a market perspective, the stocks most vulnerable might be those dependent on government defense contracts, and those exposed to consumer discretionary spending. The sequestration agreement calls for a mandatory 13 percent cut in defense programs and 9 percent from other programs. Spending cuts would also mean reduced unemployment benefits for over 3.8 million Americans and job losses for government employees, both of which will almost certainly cut into consumer spending and confidence levels.

In his opposition to sequestration, President Obama has underscored the potential economic effects of slashed jobs and unemployment benefits. Under this scenatio, the ability for consumers to spend might cause a decline in corporate profits. Last week, shares of

dropped after internal company emails showing troublesome retail trends at the world's largest retailer were leaked. “In case you haven't seen a sales report these days, February MTD sales are a total disaster,” Jerry Murray, Walmart's vice president of finance and logistics, said in a February 12 e-mail to other executives, referring to month-to-date sales. “The worst start to a month I have seen in my ~7 years with the company.” Walmart, which is expected to release its quarterly results after the closing bell on Wednesday, could be one of the first companies to feel the sequestration squeeze if no deal is reached. Other retailers will undoubtedly be effected if economic and payroll growth slows and unemployment benefits get the axe. Companies with lower-end exposure such as Walmart and

may be the first to be effected, but any decline in consumer spending will eventually find its way to the bottom line of higher-end retailers such as

and

. While the consequences of sequestration are not fully clear, few are optimistic about its effects on near-term consumer spending. Economists doubt that the current rate of slow GDP growth would be able to offset a substantial pullback in government spending. If the stock market were to fall in anticipation of an economic slowdown and consumers began to re-trench once again, the economic effects could be severe.

Among the deepest cuts to government spending under the sequestration terms would be to the defense budget. Many defense stocks have been underperforming the market as a result of investor anxiety about spending cuts, and this trend could pick up momentum going forward if no deal is reached. Many defense companies depend on government largesse to drive growth and the gravy train could be coming to an end. Major government suppliers such as

,

and

are exposed. All three of these stocks have been noticeable underperformers and are down on both a six-month basis and year-to-date -- time periods where the S&P 500 has recorded strong gains. Overall, it is not a particularly good time to be a global defense contractor, as the developed world is dealing with steep public sector debt and forced austerity.

Overall, government budget cuts have the potential to hurt stocks across the board. With the S&P above 1500 and the Dow Jones Industrial Average just under 14,000, the U.S. market remains near its all-time highs. Yet, many

, such as Blackstone's Byron Wien and Marc Faber, have warned that the market is dangerously overbought. Sequestration might ultimately prove to be the catalyst needed for a market correction.