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Why the stock market will yawn at the sequester

February 27, 2013: 11:23 AM ET

Profits have been relatively resilient during the decline in government spending over the past few years. Can that continue with the massive cuts coming?

FORTUNE -- Despite all the doomsday-like scenarios we've heard that budget cuts could wreak havoc on the U.S. economy, investors won't likely sweat it – at least not in the short-term.

To be sure, the cuts are indeed very deep. If Congress fails to strike a budget deal by Friday, $85 billion worth of government spending cuts will automatically kick in. At this point, however, the question isn't so much whether the cuts known as sequestration will hit, but rather how much they'll hurt the economy.

On Tuesday, Federal Reserve Chairman Ben Bernanke warned Congress that the sequester could do plenty of damage to the economy. He said it could slow growth by 1.5 percentage points this year. The Congressional Budget Office estimates the sequester will slow growth by 0.6 points, or 1.5% including the drag from the fiscal cliff.

"Besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run for any given set of fiscal actions," he said in prepared testimony.

Despite the alarm bells, Wall Street will probably yawn at the sequester, says Hans Olsen, head of investment strategy for the Americas at Barclays. Given that corporate earnings have been relatively resilient during the decline in government spending over the past few years, it's unlikely the cuts will be a big drag on markets.

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Between September 2010 and December 2012, real government spending that includes government purchases from businesses and paying government employees dropped by about 20%. However, earnings didn't decline. Across companies listed on the Standard & Poor's 500 (SPX), the fourth-quarter moving average earnings per share rose by about 71% during the same period, Olsen says.

Admittedly, the past may not repeat itself for a few reasons. In the wake of the financial crisis in 2008, corporate America shed millions of jobs and made deep budget cuts to stay afloat. This certainly helped strengthen many companies' profitability. What's more, the Fed's bond-buying program has helped boost the economy. Now that layoffs and cost-cutting have slowed in the private sector and it's uncertain how long the Fed will continue keeping interest rates ultra-low, could Corporate America still survive the sequester?

Olsen thinks so. He points out that sales growth at small and medium companies listed on the Russell 2500 has exceeded large companies across the S&P 500. This speaks to the strengths of the nation's domestic economy. During the last three months of 2011 sales rose by 8.387% at small and medium sized firms, higher than 6.87% at big firms. The trend continued each quarter throughout 2012, although the gap has narrowed, and sales growth has slowed for firms of all sizes.

Olsen forecasts the sequester will probably reduce growth by a mere 0.5 percentage points at most this year.

The worry perhaps is not so much the $85 billion worth of cuts alone. After all, the Congressional Budget Office predicts that government agencies would reduce actual spending by only $44 billion, with the remaining cuts spread over future years.

The bigger problem could be that the sequester will kick in with little notice, giving policymakers and the broader public reason to think that more budget cuts would be okay. If that happens, who knows how markets might react.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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