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Sequester, One Step Back And Two Steps Forward

 January 03, 2013 03:53 PM

(By Mani) The fiscal cliff deal winding its way through Congress promises to delay automatic defense cuts until March 1, 2013, giving Washington a bit more time to avert sequestration.

Yet the details of the patch and the way it was passed suggest prospects for a lasting deal are slim. It seems the easiest path to overturning sequestration would have been to include it in a broader fiscal deal that used incremental revenue (i.e. Taxes) to offset sequestration cuts.

With the revenue fisticuffs presumably concluded, sequestration will apparently be tackled in the context of a February debt ceiling showdown in which Republicans promise to keep the focus squarely on spending cuts.

"Asking to restore already cut funds will be like waving a first class boarding pass on an economy-only flight. We expect defense stocks to come under sustained pressure in the coming days as the dimensions of the challenge are better understood," Oppenheimer analyst Yair Reiner said in a client note.

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Though the Senate deal delays sequestration by two months, defense doesn't get a free ride. Half of the $24 billion price tag for the delay will come by cutting discretionary spending, including to defense.

In effect, Congress is letting half the sequestration go through, though under a different name and a slightly different budgetary paradigm. Tellingly, the bill appears to deal with sequestration almost as an afterthought, in the final three and half pages of a 158 page law.

"The section that deals with sequestration is like a caboose attached with a shoelace," Reiner said.

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The key question, when the two-month sequester delay is up, and the debt ceiling is reached, is who will pay to attach the caboose more securely. With the first fiscal cliff averted, Republicans will presumably nix any attempt to pay down the sequester with additional revenue.

Democrats, meanwhile, will resist attempts to offset sequestration with spending cuts elsewhere. A solution may be lurking, but it isn't obvious where.

In the final weeks of December, markets were hoping that a grand bargain being negotiated by President Obama and Boehner might replace sequestration with a much smaller and more orderly set of defense cuts. However, that optimism appears to have been misplaced.

"It looks to us increasingly unlikely that sequestration can be substantially averted," Reiner noted.

The difficult political calculus could put substantial pressure on the defense group in the days ahead while investors have been factoring sequestration as a low- to moderate size risk.

"Factoring it in as a higher- probability risk means sizing the addressable long-term DoD market as 5-10% smaller than previously believed," Reiner added.

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