Debt Ceiling Impasse – July 2011

July 21, 2011

Dow Jones Average: 12,572
S & P 500 Index: 1,326


Debt Ceiling Impasse

Opinion polls show that most Americans want low taxes (for themselves anyway), robust Social Security and Medicare benefits, and a balanced federal budget. The problem is that mathematically it is impossible to satisfy all these conditions at this time. Federal tax receipts only cover sixty percent of current outlays; the other forty percent is borrowed funds from domestic and foreign buyers of treasury paper. While some members of Congress have pledged to never raise taxes, others have made equally strong commitments to defend Social Security and Medicare. The ideological divide in Washington has been bridged with increasing levels of debt for the past ten years. The newly elected House Republicans, predominately from the Tea Party wing of the party, are now threatening to block that bridge.

When the Bush Administration requested more borrowing authority to cover tax cuts, two wars, and a prescription drug benefit, Congress obliged by raising the debt ceiling on seven occasions. The Republican dominated House is unwilling to grant a similar request from the Obama Administration. The apparent hypocrisy is explained by the changing make-up of the Republican Party. More moderate Republicans either retired or were defeated in primaries by candidates with Tea Party backing. This new crop of freshman, GOP members vehemently oppose using debt or financial rescue packages to bolster the economy.

President Obama has attempted to rise above the partisan fray, proposing a four trillion dollar deficit reduction plan that closes tax loopholes, ends subsidies, raises taxes on the wealthiest Americans, and cuts outlays for social programs such as Medicare. While the proposal seems logical to many Americans, members of Congress have resisted such a grand compromise. Congressional districts are drawn in such a way that members of the House represent narrow constituencies that abhor one part or another of the President’s plan. If the partisan stalemate continues for two more weeks the U.S. will not have enough money to pay its obligations.

The impact of a forty percent reduction in government outlays would be staggering. Some of the adjectives that have been used by Fed chairman Bernanke, President Obama, and Treasury Secretary Geithner to describe the potential fallout are “catastrophic”, “chaotic”, and “unthinkable”. Any indication that the government might not pay interest or principal on its debt would trigger a run on money market funds and banks across the world. Delaying social security checks would mean no rent or food money for many senior citizens. In spite of these possible outcomes, the U.S. Congress continues to engage in brinkmanship with the future of the world economy at stake.

The situation in Washington remains fluid, with a possible compromise being floated by certain senators as this update goes to the printer. Crafting legislation that can pass the House of Representatives is proving difficult. Hopefully something will be settled soon as time is running short. Regardless of the eventual resolution, this brush with default may have cracked the formerly rock solid trust investors had in U.S. debt securities.

Current Strategy

The two-year rally in stock prices reflects the improvement that has occurred in sales, national income, job creation, and corporate profits since the dark days of late 2008-early 2009. There are times when stocks are undervalued, when fear has driven prices to bargain levels. There are other times when euphoria pushes prices to a point of overvaluation that is divorced from economic reality. Occasionally stocks will enter a zone where they appear efficiently priced, not clearly overvalued or undervalued. From our perspective almost all stocks are now in such a zone. This means that most stocks offer investors a 50-50 proposition, an equal chance of going up or down. Since our job is to find investment bargains or sell overpriced holdings, markets that become the equivalent of a coin toss are not to our liking. With stock prices and economic fundamentals so evenly balanced, the market has become highly reactive to any news from Europe, the Far East, or Washington that might change the investment equation.

Over the past nine months we have had difficulty finding stocks that are attractively priced from a risk/reward perspective. For our more conservative, capital preservation oriented clients we have made only a handful of buys during 2011. A few large European companies made our buy list, as stock prices in Europe were generally lower due to the well-publicized debt problems afflicting the European Union. We also bought a small position in a virtually unknown technology company based in the U.S. That stock has risen about thirty percent since June, which we hope is the start of something bigger. For more risk tolerant investors we have made a dozen or so purchases in recent months. This group of new purchases, high quality companies with good business fundamentals, has done very little as a group in terms of recent share appreciation. In our opinion, the recent price action reflects the inconclusive, 50-50 nature of the market at this time. We will continue to move money from cash reserves to stocks when we find situations that are better than even odds.

The fixed income market has turned from placid to apprehensive due to the debt crisis in Europe and the political gridlock in the U.S. For the time being investors continue to use U.S. Treasury securities as a safe haven. There is a general assumption that the United States will honor bond interest and principal payments even if other expenditures are cut. The turmoil following a delay in social security payments, or other government outlays, could hurt equities and corporate bonds while pushing up the price of treasuries. Those who feel that Congress will surely raise the debt ceiling might want to recall that the TARP program was defeated on the first vote in the fall of 2008, and only passed a few days later after a huge crash in the financial markets. If the August 2nd deadline for passing the debt ceiling draws closer without resolution of the issue, we may shift assets from money market funds to straight six-month treasury bills, foreign sovereign bonds, or municipal bonds.

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