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One of the big unresolved issues of the fiscal cliff is the sequester, or the massive spending programs that were supposed to expire automatically at the end of the 2012.America’s defence contractors are expected to get hit the worst by sequestration. And the indirect impacts are expected to ripple unfavorably through much of the economy.
But in a note to clients today, Deutsche Bank’s David Bianco writes that “some sequestration is good for stocks.”
From his note:
We expect S&P to continue to rally during 4Q reporting. After that investors will turn their attention to the US debt ceiling and sequestration. We believe debt ceiling will be raised. As we argue in our note, contrary to most views, we believe significant sequestration is good for stocks and see the main threat to the rally as being the failure to put through any spending cuts in 2013.
Basically, Bianco thinks that the right kind of cuts would be favourable to U.S. debt metrics and in turn instill some confidence. Here’s more on Bianco’s thoughts from a note he published on Thursday
Fine-tuning sequestration is the best case scenario: Likely S&P 500 target 1600
We see the upcoming deadlines as an opportunity to improve the deficit. Slowing longer-term spending is key to stabilizing debt/GDP, but material 2013 cuts are needed for credibility. Thus, we think the best negotiated outcome trims the $70b sequestration for 2013 to ~$50b but maintains $1.2t in cuts over 9 years. Adding timing flexibility and opening more of the budget to cuts would cushion GDP impact, but cuts to entitlements and defence must occur under any credible plan. Thus, we favour modified sequestration.
Sequestration without modification: Likely S&P 500 target 1575
At this time, unmodified sequestration appears to be a very possible outcome. However, near-term support should still be strong at 1400 for the S&P in this scenario and we reiterate our 1575 year-end target. This outcome would pressure defence and many health care stocks; however, we think this risk is largely priced into those industries and the broader market would rally on a healthier fiscal outlook. GDP must demonstrate its ability to absorb the shock and still expand in 2013, but we think this is likely and 1575 should be reached by year-end likely with a late 2H rally after a range-bound summer.
Here’s a breakdown of sequestration from Bianco’s note:
Photo: Deutsche Bank
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