Looking Past the Debt Ceiling

For the last year I have taken a more top down approach to investing because of the extraordinary actions taken in both fiscal and monetary policy. My argument for this approach is that fundamental earnings are less meaningful to stock performance when the outlook for prices (ie. inflation vs. deflation) becomes more unstable. Both wild swings in fiscal policy from stimulative to austere and repetitive monetary stimulus challenge the firmness of my 5-10 year outlook.  

The game of chicken in DC likely ends with fiscal austerity, in my opinion. The only question is whether a partial shut down of the government occurs first. Both sides are calling for tighter spending, just in different areas. The Democrats would like to increase the tax rate on higher incomes to help reduce the deficit as well. Whether taxes are included or not, government spending likely declines. After the craziness, our fearless leaders likely drive home austerity measures similar to what the UK put in place lest year.

Assuming severe budget cuts occur, either due to a partial government shutdown or through the congressional appropriations process, the UK is a good leading indicator of economic growth. A slowing trend is fairly obvious due likely to the austerity measures taken. This suggests the stock market declines and longer-term treasury yields fall.

Secondly, to tackle the likely downgrade of U.S. debt from Aaa to Aa1 I look at Japan in 1998 when the country lost its Aaa rating. At the beginning of April 1998 Moody's changed its outlook on Japan debt to negative. The yield on the 10-year was almost 2% and then moved down to just over 1.4% by June. By October the yield was well below 1% as the Russian Financial Crisis unfolded beginning in August. In November Moody's performed the actual downgrade. After the actual downgrade yields increased to over 2% by January 1999.

A couple things to keep in mind that were different from the current situation in the U.S. The downgrade coincided with the debacle known as Long Term Capital Management that roiled the world markets. The downgrade also came at the end of a recession, as illustrated by a healthy recovery in the stock market from about 13,000 in October 1998 to almost 18,000 by mid-1999. It is also important to note that the downgrade was due to ''uncertainties and heightened risks over the long term arising from economic and policy weaknesses that have led to significant deterioration in the government's fiscal position."

My takeaway from Japan and the risk to treasury yields from a ratings downgrade is that yields tend to reflect fundamental economic. Downgrades by ratings agencies can cause short-term volatility but ultimately reflect the economic growth outlook.

So where does that put me? Over 60% of my IRA is invested in 30-year treasuries, and a further 15% is in cash, as I play the slowing economy and potential for deflation. In short, nervous. However, as I continue to run the scenarios through my head I reach the same conclusions:

(1) The probability of the U.S. missing a debt payment is very low and our ability to meet future debt obligations is among the best in the world. This combined with the liquid treasury market makes treasuries the likely on-going safe haven in an increasingly risky world.
(2) The issue is a political issue about two competing views about the future (see my earlier post on Democrats vs. Republicans).
(3) Austerity is very likely, which should cause slowing economic growth.
(4) Debt problems in Europe, slowing growth in China, and risk in Japan suggest there could be a "black swan" event in the near future that pushes investors to Treasuries.

So I may push my equity positions to more conservative waters, but I likely remain in Treasuries for now. That said, I'm watching price movements very closely to get some sense of how the market may react. 

Pro Deflation Republicans vs. Pro Inflation Democrats?

It's no secret, the U.S. has a debt problem. John Mauldin and Jonathon Tepper bluntly state the problem below in their book "Endgame: The End of the Debt Supercycle and How it Changes Everything." A book I just finished and recommend to anyone interested in a thoughtful, well researched, analysis of the debt issues in the world.

"We're pretty much bankrupt, and it is extremely unlikely we'll be able to close the gap between what we collect and what we'll spend. It [the IMF] adds that 'closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.' Fourteen percent is huge. That is more than a trillion dollars to save a year to get our fiscal house in order."

Congress is in a heated battle over how to address the problem since there appears to be enough political will to not "kick the can down the road." A simplistic summary is the Democrats favor Keynesian-like stimulants that would potentially grow the economy out of the debt burden while the Republicans favor spending cuts to stop the growth of debt and eventually pay it down. Of course there are multiple opinions that vary across the board on both sides of the aisle.

House Republicans are using their ability to postpone a vote on raising the debt ceiling as leverage on the Democrats to agree to spending cuts without raising taxes. It is a gigantic game of chicken that risks the worst possible outcome (a debt default by the U.S.) to decide between two unpleasant one-to-five year paths (a combination of higher debt/ higher taxes or severe austerity). Who wins likely has enormous implications for investors and where they should put their money.

In this entry I analyze the potential paths forward for the country and conclude that both have merits, but require significantly different investment strategies. A plan leaning more to the Democrats likely encourages inflation to grow out from under the debt, risking future asset bubbles and structural issues associated with hyper-inflation during the next 1-5 years. A plan favoring the Republicans likely results in deflation, risking a severe near-term recession but likely improves the financial heath of the country in the long run (5+ years).

One Theoretical Democrat Path Forward
Democrats appear more willing to accept deficits over the next five years in order to stimulate the economy. They generally argue higher taxes on the wealthy and revenue initiatives that close tax loopholes should help to keep the deficit manageable while government spending stimulates the economy. The effectiveness of the last round of stimulus spending on the economy is debatable, but definitely increased our debt levels, as illustrated by the larger deficits under President Obama.

Higher deficit spending means, due to a well defined accounting identity, either private debt needs to be reduced (impacting Consumption and/or Investment), or the country needs to run a trade surplus. The country is currently running a trade deficit, which did shrink in April but widened in May. As a result of both a growing budget deficit and large trade deficit, Consumption and Investment must contract. Put differently, consumers spend less and businesses invest less. Not a great recipe for economic stimulus.

But what about the shrinking trade deficit? No wonder President Obama is interested in improving the manufacturing capability of the country. It offers a win-win outcome that should increase exports and provide much needed jobs in the economy. However, the capital needed to improve the manufacturing capability is getting soaked up by the increasing government debt, resulting in a more challenging environment for manufacturers in need of capital. So, a tempting solution is to weaken the dollar, which should reduce the trade deficit as U.S. manufacturers become more competitive in the world economy and enable more capital to flow to business investment. One problem, most developed countries are pursuing a similar strategy through loose monetary policies in order weaken their currencies, or as many have put it - the race to the bottom.

But budget deficits can encourage inflation, especially when coupled with a loose monetary policy. This combined strategy potentially weakens the dollar and spurs export growth. As the overall debt level increases in a country it becomes increasingly tempting to encourage inflation in order to inflate an economy out of debt. A simple example is by encouraging inflation, a country would theoretically enable wages to rise at an accelerated rate above real economic growth, resulting in more cash flow to go towards fixed-rate interest payments and pay down the principal. Of course new debt issues become more expensive as interest rates go up and thus the structure and term of the debt outstanding becomes critical to determining the feasibility of this strategy. The other risk is the country over inflates and ends up with hyper-inflation, a scenario that is extremely destructive to economic health.

President Obama appears quite supportive of monetary easing by the Federal Reserve. No wonder, if handled properly it could provide economic stimulus, encourage inflation to ease the debt burden, and weaken the dollar. By weakening the dollar exporters increase their competitiveness and manufacturers producing outside the U.S. are encouraged to invest within the U.S.. Homeowners with large mortgages should be supportive of this path. Investors with large debt positions, including foreign investors in U.S. treasuries, should hate this path since the value of their holdings likely decreases. Investors in the stock market also likely hate this path since the P/E of publicly traded companies likely declines significantly due to a hidden tax on their profits from inflation. The other complication to pursuing this path is the efforts of other countries with high debt levels (Japan, Europe (Greece, Italy, Portugal, Spain, Britain), and possibly China) to also weaken their currency. Thus the Fed needs to become even more aggressive and may get swamped by a strengthening dollar simply due to its status for safety should defaults hit other countries. 

Bottom line for the Democrats - Unless they address structural issues in the U.S. tax code and walk a very delicate line of controlled inflation, their path may actually slow economic growth, over-inflate, or result in a debt burden too high for the markets to stomach. Gold and other precious commodities are good investments, developing countries, and growth stocks for some period of time.

One Theoretical Republican Path Forward
The Republicans are faced with the same set of issues but are arguing a different course based on their core belief of smaller government. Republicans seem to offer a fairly simplistic solution: restore fiscal discipline without new taxes (i.e. cut spending) and the economy will recover. This may prove true in the long run but likely hurts growth in the short-term. It also puts a disproportionate burden on middle and lower class residents who likely see their benefits cut. The burden may prove too great for the majority of the population.

Let's walk through what the Republican path likely causes in the future. As the GDP accounting identity defines, by lowering and even eliminating the fiscal deficit there is the opportunity for private debt to increase (through either consumption or investment spending) and/ or an expansion of the trade deficit. Good so far, both can stimulate the economy. One immediate negative impact is job loss in governments, which is already in excess of half a million over the past 2 years. This job loss is certainly not helping the economy in the near-term but Republicans argue it is reducing the waste.

Going back to the accounting identity, there are likely a couple complications. The first is timing, reducing government spending contracts GDP in the short-term. One can argue that consumers may increase spending to make-up the difference, however I believe the high consumer debt levels likely delays any pick-up in consumer spending. Businesses are in a healthier financial position to invest and spur growth, but with weak consumer demand and declining government demand businesses may be hesitant to add to a capital base.

The near-term perception of a more sustainable financial position for the U.S. may cause the dollar to strengthen due to less worry about inflation and unsustainable debt burdens relative to foreign countries. A stronger dollar paradoxically hurts exports, weakening GDP.  At this point the debt-to-GDP ratio may actually worsen if GDP declines, hurting tax revenue. If a balanced budget amendment were added to the constitution, as some on the far right are advocating, it would trigger additional cuts in government spending to balance the budget, similar to what we are witnessing in Portugal.

A contraction in the the GDP places downward pressure on prices as demand declines, likely encouraging deflation in the economy. The Fed might counter this pressure by announcing QE3+, which in effect monetizes the outstanding debt. This may encourage some growth but the high debt burden of many consumers likely makes the Fed's impact fairly weak. Should the Fed fail to offset deflation the country risks falling into a deflationary cycle where salaries decline, increasing the debt leverage on consumers and resulting in even slower economic growth. Defaults increase, hurting banks and therefore lending dries up, causing asset prices fall. In short, a full blown depression that may prove difficult to pull out of.

The positive is it resets the bar, forces everyone to sober up, and sets the country up for prolonged healthy economic growth. Of course it doesn't need to be that dire, so long as the Republicans allow some flexibility for the government to invest in worthwhile capital projects and clean up the tax code.

Under this scenario investors should be placing their money in treasuries, high quality debt, food and other non-discretionary companies.


Default
Think bad. Really really bad. Global trade shutting down, interest rates spiking, stocks tanking. No one wins, especially the people in Washington DC since they likely will be voted out. Put your money in cash.