What the Budget Deal Means for You

Somebody pinch me, because I think I’m dreaming. A small contingent of Democrats and Republicans actually came to an agreement – and over the budget, of all things!

It all goes back to the end of the government shutdown in October. Unable to agree on a 2014 budget at the time, Congress appointed a select number of Senators and House Representatives from both parties to hammer out a budget proposal by December 13^th.

The Conference Committee, lead by Senate Budget Chairwoman Patty Murray (D) and House Budget Chairman Paul Ryan (R), announced on Tuesday evening that it finally achieved something no one in Washington had been able to do in four years – package together a bipartisan budget proposal where both parties get some of what they want. And it’s not just a one-year deal but two, covering fiscal years 2014 and 2015, giving us a bonus year to boot.

“It is an important step in helping heal some of the wounds here in Congress,” Murray praised the team’s accomplishment at the Tuesday press conference.

“By having a budget agreement that does not raise taxes, that does reduce the deficit and produces some certainty and prevents a government shutdown, we think is a good agreement,” Ryan extolled the plan’s bridging effect at a Wednesday press meeting.

At least, it is hoped it will prevent a government shutdown. To prevent another closure, the proposal must be agreed upon by both Congressional houses before the government’s temporary funding runs out on January 15^th. If they miss that deadline, they will then have until February 7^th to get their act together or risk a government default.

One deadline down, two more to go. Will they make it? Does this latest proposal contain enough presents to make both sides happy for the holidays? Let’s have a look inside Santa’s sack and see what his little elves in the Conference Committee have crafted in their workshop.

The Deal’s Achievements and Shortfalls

The deal seems to be one of those rare compromises where you can practically see the negotiators around the table trading cards with each other. Here’s what they traded:

• Reducing the current $109 billion per year in sequestered cuts by approximately $60 billion (some 27.5%) over the next two years – $40 billion in 2014 and $20 billion in 2015.

• Reducing the deficit – which totalled some $759 billion for fiscal year 2013 – by about $20 billion (2.6% smaller).

• Increasing revenue through user-fees that target specific areas of the economy rather than through nationwide taxes. Raising airline passenger fees, raising federal employees’ retirement contributions, and increasing premiums charged for pensions were just three such recommendations.

• Saving $25 billion by not extending the emergency unemployment benefits (EUC) into 2014, allowing them to expire this December 31^st.

• Allowing cuts to physician pay scheduled for January 1^st to proceed, which will reduce payments to doctors who treat Medicare patients by 24%.

Yet some of the measures are being seen as postponements that are simply being pushed back to a later day – such as the reduction to the sequester, where the $60 billion in cuts being spared over the next two years are simply being moved to the end of the line, extending the sequester by two additional years from 2021 to 2023 for certain programs such as Medicare.

Other measures are likely to be contested as being too detrimental to the economic recovery, such as not renewing EUC, which will see some 1.3 million unemployed – about 10% of the total unemployed – cut off from unemployment benefits. This by itself represents some $25 billion taken out of the economy, which in effect cancels out nearly half of the reduction to the sequester. The end result is that cuts are simply being moved from the general economy (across-the-board sequester) to a specific part of the economy (the unemployed).

While many are optimistic over the plan, it is not a slam dunk to preventing another government shutdown – especially since it does not address the debt limit increase which is at the very center of the negotiation table, leaving a great deal of debating to be done in Congress.

“It leaves a lot undone and isn’t close to the grand bargain that was sought,” executive director of the Concord Coalition, Robert Bixby, expressed his concern to Bloomberg.

Republican Senator Marco Rubio has already announced his intention to vote against the plan. “It cancels earlier spending reductions, instead of making some tough decisions about how to tackle our long-term fiscal challenges caused by runaway Washington spending,” he wrote in a statement e-mailed to Bloomberg.

Echoing that disappointment was Republican Senator Rand Paul, who sees the moving of sequester cuts to the end of the line as a cop-out. “I think it’s a huge mistake to trade sequester cuts now, for the promise of cuts later,” he rebuked to Bloomberg.

Others, like Democrat Harry Reid, are optimistic the plan will deliver what is needed at this time. “The agreement will roll back the painful and arbitrary cuts of the sequester and prevent another costly government shutdown,” he supported.

Even House Speaker John Boehner came out to defend the deal as a launch pad to a final agreement, offering some rather harsh words which many believe were directed to dissenters within the Republican party. “They’re using our members, and they’re using the American people for their own goals. This is ridiculous,” he scolded at yesterday’s press conference. “If you’re for more deficit reduction, you’re for this agreement.”

With mid-term elections coming up in the summer, Republicans don’t want to look like the bad guys during these budget talks, which is one reason we can expect fairly smooth sailing through the negotiations – and no government shutdown.

Markets Step Back – For Now

Equities and bonds dropped on the news of the deal, with the S&P 500 losing 1.17% and the 10-year Treasury yield gaining 5 basis points on Wednesday on the expectation that the proposed budget will be approved and reduce the need for continued Federal Reserve stimulus. Add last week’s strong employment report and lower unemployment rate and we have a genuine possibility of the Federal Reserve reducing its monthly bond purchases sooner than previously anticipated.

“We’ve moved much closer for the Fed to taper in December,” Jeffrey Kleintop, chief market strategist at LPL Financial, assessed in a phone interview with Bloomberg. “Markets are increasing their views that we are a week or so away from tapering because of improving economic data and clearing the hurdle for a budget deal. This deal is great, it’s a positive, but also a negative because it could prompt the Fed to taper sooner.”

What is more, the budget deal’s reduction of sequester cuts would give the Fed more freedom to begin tapering stimulus. The reasoning? If the government sequesters less, then the Federal Reserve doesn’t need to stimulate as much. After all, in several of its recent press releases, the Fed did list the government’s tight fiscal policy as one reason why the FOMC was being so accommodative.

UBS AG’s chief investment officer Alexander Friedman cautions investors that a period of adjustment may be here. “The budget deal itself is at best a signal that we won’t shut the government down at the start of the new year,” he clarified to Bloomberg Television. “It’s a low base that we’re declaring victory from. The key message for 2014 is that the real economy is getting better. For investors however, it’s probably not going to be the same sugar high we’ve seen for the last five years.”

It looks as though the time is upon us to adjust our portfolios to less stimulus and to the pullback that will likely follow. Without so much “sugar” from the Fed, 2014 might not give us the same +30% per year returns we have grown accustomed to since 2009.

However, the economy is improving, which will support the markets into 2014 and beyond. Our mission now is to rotate out of those positions that stimulus favored (such as bonds) and into positions that will benefit from an economy on the mend (such as energy, freight, and industrials).

And be sure to keep extra cash on hand to buy some bargains on any upcoming dip. Once the initial tapering announcement and budget talks are behind us, look for markets to resume their upward trajectory on the back of rising GDP and falling unemployment. Remember that the Fed stepping out of the market is a good sign over the long term, even though it may hurt a little at the moment it happens.

Joseph Cafariello

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