With barely a week to go before $85 billion in automatic government spending cuts kick in, Wall Street is holding its nerve.
The Dow Jones industrial average has gained 6.8 percent since the start of the year as investors largely ignored the latest installment of Washington's budget drama. The Dow Jones climbed close to its record level at the start of the month and the Standard & Poor's 500 notched up a streak of seven straight weeks of gains, before easing back this week. Even after its weekly loss of 0.3 percent, it's still up 6.3 percent this year.
Wall Street is betting that the cuts, which the Congressional Budget Office estimates will take 0.6 of a percentage point of economic growth this year and cost 750,000 jobs, won't be enough to derail the recovery. Investors may also have become used to Washington brinkmanship, having seen last-minute deals brokered after a series of political standoffs.
David Bianco, chief U.S. equities strategist at Deutsche Bank, says the automatic spending cuts could actually be a "net positive" for stocks, despite the drag that they would put on the economy. That's because a set of known, measurable spending cuts are better than no budget reduction at all.
"Significant spending cuts are needed," Bianco says. "Until that happens, people are going to worry that this is still a problem that needs to be solved."
Bianco estimates that the impact of the spending cuts on corporate profits will be limited, reducing the income of companies in the S&P 500 index by just 2 percent.
Sitting on the sidelines during the political wrangling in Washington hasn't been a winning strategy in recent years either, as stocks have rebounded and come back stronger each time, says David Kelly, chief strategist at J.P. Morgan funds.
The Dow has returned 24 percent since the end of August 2011, after plunging following the showdown that month over raising the country's borrowing limit. The index is also 12 percent higher since bottoming out in November after the election, when investors sold stocks on concern that a divided government wouldn't be able to come up with a budget compromise.
"Twice already investors have learnt the lesson that if you wait for everything to calm down in Washington you'll miss out on the rally," Kelly says.
Analysts and investors generally agree that the huge amount of attention being paid to the $85 billion of cuts far exceeds the actual impact they will have on the $16 trillion U.S. economy, particularly given that the cuts will be phased in over time, and some will ultimately be reversed.
The cuts are very much a problem of Washington's own making. The Budget Control Act, signed in to law in August 2011, was meant to end the nation's debt crisis and force lawmakers to come up with a measured approach to reduce the deficit. The automatic spending cuts were included in the bill with the idea that they would be so unpalatable to lawmakers that they would have a strong incentive to avoid them by making a deal to reduce the budget deficit.
With time running out to broker a deal, the cuts looks likely to go into effect on March 1. Then the focus will likely turn to a March 27 deadline that could result in a government shutdown.
That may sound scary, but even that outcome doesn't necessarily translate into a slumping stock market, says Tobias Levkovich, an equity strategist at Citigroup. When President Bill Clinton and House Speaker Newt Gingrich clashed over the budget in late 1995 and early 1996, the market actually rallied, with the S&P 500 gaining about 4 percent over the course of the shutdown. That suggests that investors were focusing on other factors such as economic growth and earnings.
As the intensity of the debate around cuts and shutdowns picks up, investors shouldn't overreact. "We don't think it's a great idea to trade around the vicissitudes of Washington behavior," says Levkovich.
Defense is one area where the cuts will be felt acutely, and investors have responded accordingly. The Pentagon is preparing to slash $46 billion from its budget year, which runs to Sep. 30, Defense Secretary Leon Panetta told Congress on Wednesday.
Defense giants Lockheed Martin, Raytheon and General Dynamics have all slumped this year, while the broader market has rallied. Lockheed Martin, which makes fighter jets including the F-22 Raptor and F-35 Lightning, has fallen 4.5 percent this year to $88.12. General Dynamics, which builds ships for the navy has dropped 2.8 percent to $67.32.
Chris Bertelsen, chief investment officer at Global Financial Private Capital, says the slump is an opportunity for investors to pick up stocks at a good price and lock in high dividend income. Lockheed Martin, for example, pays a dividend of 5.3 percent on its stock, more than double the average rate of 2.1 percent in the S&P 500.
In any event, investors know full well that the most important, and politically sensitive, U.S. budget problem is far from resolved: controlling the runaway growth in spending by government entitlement programs like Medicare.
"What we need are entitlement cuts in the long run, rather than discretionary cuts in the short run." says JPMorgan's Kelly. "It's obvious."