Senior Managing Director, Invesco
"Washington cannot continually operate under a cloud of crisis."
- President Obama comment to CBS anchor Scott Pelley, Feb. 3, 2013
Sequestration. Not a word most of us expected to add to our daily vocabulary. Yet as of March 1, there were somewhere in the neighborhood of 18 million search results for it on Google. And on that day, sequestration not only became a permanent part of our dialogue, it also became our reality: With no last-minute fix coming out of Washington, the first segment of the $1.2 trillion mandatory federal spending cuts began as scheduled.
The White House has projected ominous effects of these cuts across a wide band of the nation. Republicans argue it won't be that bad. For investors, either scenario could be true - the effects could be quite severe, or they could be relatively minor. It's all quite exhausting, frankly.
Today, I want to focus on how the potential outcomes of sequestration could affect Americans' paychecks and discuss ways investors could increase the income-producing potential of their portfolios as they seek to fill the gap in their employment income.
The big picture
Sequestration refers to $1.2 trillion in federal spending that must be cut over the next nine years, $85 billion of which is scheduled to occur during the remainder of this fiscal year, which ends Sept. 30. Due to the nature of the sequestration legislation, these cuts will occur across the board — the Office of Management and Budget calculates that nondefense programs will be cut by about 5% annually, and defense programs will be cut by about 8%. However, since this year's cuts are starting at almost the halfway point of the fiscal year, the cuts will effectively be about 9% for nondefense programs and 13% for defense programs.
The scope of cuts
Much of the focus has been on the cuts to the Department of Defense, which are expected to affect defense contractors and the 800,000 civilians in the Department of Defense work force. But a wide variety of nondefense jobs are also expected to be affected – either through layoffs or reduced hours. According to the White House:
- 10,000 teacher and aide jobs would be put at risk, and funding for up to 7,200 special education teachers, aides and staff could be cut.
- Scientific research awards would be cut, affecting thousands of scientists and students.
- The USDA's Food Safety and Inspection Service may have to put all employees on leave for approximately two weeks.
- The FBI and other law enforcement entities would reduce their capacity.
- US Customs and Border Protection would have to reduce its work hours.
- Most of the Federal Aviation Administration's nearly 47,000 employees would be put on leave for up to two days per pay period through the end of the government's fiscal year.
- The Transportation Security Administration would need to initiate a hiring freeze, eliminate overtime and put its 50,000 officers on leave for up to seven days.
- Many of the 398 national parks across the country would be partially or fully closed.
- Loan guarantees to small businesses would be reduced.
The effects of sequestration will be felt over time. For example:
- Beginning in March, certain federal unemployment checks were to be reduced by about 9%.
- Also starting in March, checks to doctors and others who care for Medicare patients were to be cut by 2%.
- In April, many of the employee furloughs and layoffs are expected to begin.
Looking past sequestration, the budgetary authority to keep the federal government running expires on March 27. Without action by Washington, there could be a government shutdown that affects even more employees. President Obama and Speaker of the House John Boehner indicated Friday they are willing to support a resolution that would continue the government's ability to operate. But given Washington's current state of disagreement, the possibility of a government shutdown is one more reason to ensure your finances are in order.
Are you still with me?
Sequestration and your financial plan
If you expect your paycheck to be affected by sequestration, you need to talk with your financial advisor as soon as possible. Your advisor can discuss a variety of issues with you, including whether you should reassess your contribution levels to your portfolio, whether you should adjust your asset allocation to reduce your risk, and, perhaps most important, whether you can increase the income-producing potential of your portfolio.
There are many asset classes that income-oriented investors can consider:
- High current income. Investors who need to immediately maximize the income from their investments could consider high-yield bonds, emerging markets debt and senior loans.
- Capital preservation and income. Investors wanting to preserve their capital while also drawing income from it can consider short-term bonds and municipal bonds.
- Capital growth and income. Investors who still need to grow their capital while taking income can consider dividend-paying stocks, convertible bonds, real estate and preferred stock.
- Sustainable income. Investors needing to draw income over a lifetime can consider intermediate-term bonds, investment-grade bonds and a multi-sector bond strategy.
Each of these asset classes comes with its own risks and there is no guarantee that any of these asset classes will be successful. Talk to your financial advisor to make sure that any portfolio changes you make are in line with not only your income needs, but your risk tolerance and time horizon as well.
No one can predict which of the forced budget cuts known as sequestration will ultimately be put into effect. That's why planning for the worst now is a good strategy to ensure you're prepared no matter the outcome. And no matter what crisis – or vocabulary word - comes out of Washington next.
The opinions expressed are those of the author, are based on current market conditions as of March 11, 2013, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.