The confluence of events over the past few weeks continues to rattle markets, with recent events culminating in Friday night’s downgrade of the United States credit rating from AAA to AA+. The downgrade is a source of embarrassment for our nation. While one can agree or disagree on whether the action should have been taken, or whether the United States is truly a AA+ credit, the fact remains that the United States is on an unsustainable fiscal path and needs to find a way to correct its long term course.
An opportunity to begin that redirection was lost during the debt agreement reached last week. As the market (and S&P) have had time to analyze and digest the deal that has been negotiated, it is becoming clear that the emperor has no clothes. The vast majority of the cuts in the current settlement do not take place until the out years (years 5-10) of the 10 year plan, with a negligible portion of the cuts taking place in the next 12 -18 months. Further, there is little faith that the new committee of 12 will be able to come to agreement. On the off chance they do agree, their proposal may be dead-on-arrival upon reaching Congress if past history is any guide (think Bowls Simpson plan). In addition, the next Congress can always change the rules once elected so all the items which are slated for the out years may never be implemented. The disappointing lack of fiscal leadership in the US on top of the disappointing fiscal leadership on display in Europe has exacerbated global tensions creating a level of uncertainty that is the current witches’ brew for markets.
All of this turmoil increases the chances of another near term recession. The economy has been able to grow albeit slowly despite 9%+ unemployment and the state and local government cutbacks we are seeing across the country. If the current uncertainty about regulations and taxes results in reductions in business spending and a nervous consumer retrenches, then a recession could be forthcoming.
All that said, we believe that many of the fundamental underpinnings of the economy provide a sustainable base of long-term economic vitality – if the policy makers get it right. Unlike 2008, for the past 24-36 months we have been in the midst of a deleveraging process that has made this recovery incredibly weak. The benefit is that debt has not been available to create a lot of unsustainable economic activity. Further, we are optimistic that legislators have been backed into a corner and we will begin to see difficult decisions being made (and if that is not now, then after voters are heard in 2012). The changes necessary will require sacrifice for all Americans in some form or other, including the jobs of those politicians that choose not to make the difficult choices.
With all of this uncertainty comes volatility and with volatility comes opportunities. We look for opportunities that present themselves in the market place, particularly in such times as these. We do not believe this is a time for wholesale changes to asset allocation or to portfolios. That said, we think that there is an opportunity to continue to move equity portfolios towards companies with strong balance sheets, strong cash flows and dividend yields that meet or exceed yields on government 10 year bonds. Also, we do expect that the fiscal issues of more mature economies such as the US, Eurozone, and Japan do result in an anchor that slows growth. To that end, we continue to seek investment in companies and regions that have exposure to growth. Finally, the combination of growth in developing economies combined with the possibility of the US printing money to pay off its debts increases the likelihood of inflation at some future date. Hard assets including gold, other commodities and real estate directly, along with companies tied to these assets indirectly are likely to perform well in an inflationary environment.
Our corporate bond portfolios also continue to be comprised of companies with sustainable cash flows and a strong capacity to repay debt. In the municipal bond market, we continue to seek out the debt of those issuers we perceive to be of the highest quality. In an inflationary environment, we believe these actions will provide the best outcome towards preserving purchasing power for investors.
In closing, we continue to be guided by the fundamentals and our investment objectives for your portfolio. As always, we invite you to contact us or your portfolio manager to discuss your portfolio in more detail.
Bob Bilkie, CFA
Denise Farkas, CFA
Chief Investment Officer