Sequestration Risk Becomes Reality, Defense Stocks Start To Underperm

With March 1st approaching, the realization that sequestration may actually hit is setting in. Washington is nowhere close to a solution and the blame games are running rampant. The White House is now playing a "game of chicken" to see if the Republicans blink.

Politico: With the parties at an impasse on stopping across-the-board budget cuts set to hit March 1, the White House is prepping another multimedia, cross-country drive to stoke public outrage against congressional Republicans.

Certain that the political winds are in their favor, they’re forgoing serious negotiations for a high-risk public offensive, banking almost entirely on the president’s ability to persuade. They believe that the GOP will be scared of taking the blame from an angry public — and the White House says this is just the kind of thing that gave them the victory they claimed in the fiscal cliff fight and the most recent standoff over the debt limit.

The markets are beginning to take notice. In spite of the overall US equity market having performed quite well recently, the defense sector, which is where half the cuts will be focused, is starting to underperform.

Most expect the situation to be resolved right before or shortly after the deadline. But therein lies the "tail risk" - the possibility that this deadlock remains in place over a longer period with some material consequences for the US economy.

Barclays Research: - As has been the case over the past few years, negotiations could go down to the wire. Unlike the past few negotiations, though, we think that the likelihood of the sequester hitting on March 1 are fairly high. By late March, however, we suspect the across-the-board cuts will end up being replaced with equivalent deficit cutting measures as part of the continuing resolution (CR) negotiations. Nevertheless, with few economists expecting the sequester to stick at all, the risks to markets in the event that gridlock sets in remain to the downside...