Thoughts on the Deficit Crisis

I thought I would send something out regarding the current debt standoff in Washington as I seem to have as many people asking about my thoughts as I did during the banking crisis in 2008.

First, a few caveats. This is my current thinking on the issue and it could be obsolete before you even read this. I reserve the right to change my mind as events on the ground dictate. The other disclaimer is that political discussions regarding money and its distribution throughout the economy should be discussed using scenarios dealing with what is likely to happen versus what anybody might prefer to see implemented from above. Many of you have heard me over the years me introduce a discussion about politics as it relates to money by saying the end result usually is similar to what will happen if I drop a pencil from my hand to the ground. Whatever I’d prefer to see happen, the pencil is going to fall to the floor. That’s just the way it is. Now with that out of the way here’s what I see happening. We’ll briefly separate this discussion into three parts: a political event, an economic event and the market’s likely reaction to both.

Politically, I believe that neither political party will compromise until 11:59 of the crisis. Think of it this way. You could be the most ardent Tea Party Congressman from a deeply conservative district. You could have many constituents similar to a former client of mine {a farmer from central Illinois} who once told me that “he didn’t read the Wall Street Journal because it was nothing but a liberal rag”. Your district might be filled of people like this. They sent you to Congress to straighten things out. But as a Congressmen, you know this fact {or your advisors do if they have any experience}. Your most vocal and ardent conservative constituents, the ones that are shouting “Atta boy!” on the phone lines all the way to Washington are going to be the first ones to call you when either they or some family member doesn’t receive a social security check. This same thinking works in the most deeply liberal districts. Yet the only way for each side to get re-elected next year is to be seen as the guy that stood up for their districts until the bitter end. This means voting at the last minute for some compromise and being able to go home and tell the folks they cut the best deal they could.

A best guess is that we’ll see soon a short term extension of the debt ceiling {maybe two months} or a deal cut by early August to avoid a default. Default by the August 2nd deadline is an arbitrary date anyway. It is likely that Treasury can pay its bills on that day if it wants to. But politicians need a drop dead date so that one works as well as any.

On an economic basis it is likely that if for some crazy reason the US government passes that August 2nd date and has incredibly done nothing, here’s what will happen: The sun will come up in the east, people will still have jobs, babies will be born and the Cubs will continue to lose baseball games. Whatever economic disruptions that might occur from this event will likely be short-every television station in the country can’t wait to feature the story about the person/couple denied benefit X because of the deficit impasse. Should both parties push for economic Armageddon, look to the party that is suffering the most political pain {most likely the Republicans} to cry “Uncle” first.

What most of us are concerned with is the market’s reaction to a default and what steps should they take with their portfolios. A few thoughts: As this is being written {late July 25, 2011} the markets do not believe the US Government will default on its obligations. The gyrations of the stock market are less important in this regard than the bond market and bond yields are not currently pricing in a default. If they were then interest rates all along the yield curve {bonds maturing between next month and 30 years from now} would have seen a substantial decline in price. This would have been necessary for the yields to rise to the point where investors would be willing to take on the additional default risk. Whatever the television gurus and the political pundits want to tell you, the United States is financially not in the same fiscal situation as Greece. Bonds are so far telling you that the chance of a real default-that is a situation where creditors never get paid- is very low.

For most of us though with investments in 401k’s or stock investment portfolios and with painful memories of the 2008 decline, the unanswered question is what is the likelihood that against all expectations on August 2nd there is no deal. Both political parties are willing to engage in an American equivalent of Gotterdammerung-taking the whole economic system down with them? That probability while low is not zero in our opinion. So given that, what do you do from an investment perspective?

For our client portfolios, we turn back to our playbook. The playbook is situational analysis based on historical market results. We study money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events. It gives us different scenarios regarding market activity. We use it to formulate our game plan. The game plan is a tactical and a strategic allocation of assets based on what the playbook tells us has historically occurred. It is then further refined to the specific risk/reward parameters of our clients.

Given what we currently know, the playbook is telling us is to treat the debt debate as a situation that has been priced into stocks.  Probability suggests that a default {if it’s temporary} and any market dislocations resulting from it are likely to be short lived.  Neither party will likely be able to withstand the political pain associated with its disruptive effects for more than a brief period.  That being said, markets may become more volatile in the days ahead, particularly the longer this event drags on without some resolution. In that event we would view any short term decline in stock prices as an opportunity to review markets and to potentially add to positions that we find of interest. 

First you must have some sort of understanding of your own risk/reward perspective regarding the total composition of your portfolio. Again we feel that the understanding of our playbook and our knowledge of our client’s own personal situations helps us with the asset allocation of their portfolios. Right now as an example and for reasons totally unrelated to the debt issue we have been carrying for most of this year higher than normal cash positions for most of our investment styles. Absent a significant decline in economic activity it is likely that we would view any decline in stock prices resulting from such an event as an opportunity to add to positions that we view as favorable, particularly securities with higher than average dividend yields. Away from Washington the current corporate earnings season so far is making it clear that American companies are in pretty good shape. However, should the unthinkable happen and the crisis morph into a more serious event than we will bring out the defensive pages of the playbook. As we mentioned recently,  we have them close by right now just in case.