This is written a little later than usual. The alleged deadline for Congress to raise the debt ceiling was August 2nd, so I didn’t want to write an investment comment on August 1st with potentially significant news coming out the next day. After the debt ceiling was raised, investors discovered all sorts of other things to worry about and the result was that the stock markets…well, you know. More on that later.
I received an unusually large number of phone calls this past month from clients, friends and colleagues wanting to know my thoughts on a potential U.S. debt default. I haven’t had this many concerned callers since Lehman Brothers went bankrupt in the fall of 2008. What happens if the U.S. defaults? What happens if the U.S. doesn’t default but almost defaults? What happens if the U.S. loses its triple-A rating? My most frequent response was “quit watching TV!” I thought this might be the biggest non-event since Y2K. I was evidently wrong, as investors everywhere apparently felt differently.
Last month I said that Congress will eventually vote to raise the debt ceiling which, of course, they did. What else could they do? We aren’t Greece. We have the money. Congress was not voting to decide if we COULD pay our bills. They were voting to decide if we WOULD pay our bills. OK, we don’t actually HAVE the money but we can print the money, which Greece cannot do.
Once the debt ceiling was raised, attention began to re-focus on the real problems around the globe. Would Italy and Spain institute enough austerity measures such that the European Central Bank would buy their bonds? Apparently they did, because the ECB agreed to buy their bonds. Is the United States headed into another recession? Probably so.
And then, to add to investor concerns, Standard & Poors elected to reduce the rating on U.S. debt from AAA to AA+ (Moody’s and Fitch, the other major ratings agencies, maintain a AAA rating on U.S. debt). Never mind that S&P allowed that they made a $2 trillion error in calculating the future debt/GDP ratios. S&P stated that, even without that error (it was just $2 trillion), they still would have reduced the rating to AA+. They gave the additional reason that the political process in the U.S. might make it difficult to rein in future spending increases.
I think we all would agree that the political process over the debt ceiling was less than reassuring. However, a case can be made that our political process, as ugly as it may have been, might still be better than the process (or lack thereof) that led Greece into the financial position it finds itself. It could be, perhaps, that when a nation decides to stop heading the way of Greece, the process becomes ugly and there is no way around it. This occurs in households all over America when one spouse finally decides they are spending too much and they have too much debt. The other spouse still sees things that need to be purchased and suggests the first spouse get another job to raise more revenue. It can get ugly.
A reduced rating implies that the U.S. is less likely to repay its debt. It stands to reason that, if you are less likely to repay your debts, you will be subject to a higher interest rate. That’s why 10-year bonds issued by Greece are paying around 15%. 10-year bonds issued by Italy and Spain are paying around 5%. The 10-year U.S. Treasury Bond? Two weeks ago it was paying 3%. After the downgrade by S&P, it did the opposite of what you would expect. So many investors poured money into U.S. Treasury Bonds that the yield fell to below 2.4%. Where else are they going to invest their money? It is the largest, most liquid (and, at AA+, still pretty darn safe) investment in the world. When investors start worrying about and selling other investments, the proceeds have to go somewhere.
The negative effect of the downgrade was clearly felt by the equity markets. At this writing, the S&P 500 has declined 13.3% in the first 6 days of August. This is on the heels of a 2% decline in July, the third month in a row of declines. There are no bold, clear reasons for the decline. Perhaps this should be of more concern. In 2008, the markets were plummeting but at least we had a good idea WHY. You didn’t need to connect any dots in 2008 to figure out why we were facing Financial Armageddon. Lehman Brothers, sub-prime mortgages, failing banks, etc., etc. There was no speculation. No one was sure how bad the market decline would be, but we pretty much knew why it was declining.
Today you have to connect some dots…and then you still might not get it right. This market decline is less clear but may just be returning to what we have been concerned about since 2007. This is an economic problem that was etched in stone during the early/mid 2000s. The over-leveraged consumer and the mortgage/housing crisis is going to take years to unwind. And last week investors may have realized that we could be heading into another recession.
That’s bad news for anyone, but particularly bad news for the 9% who remain unemployed. It’s particularly bad news for the homeowner who continues to watch home prices decline year after year. Below is an update of a chart I have included in previous Commentaries. It illustrates the number of monthly new foreclosure filings since 2005.
I maintain it is difficult to have any kind of a robust economic recovery without a recovery in the housing industry. And it is difficult to have a recovery in the housing industry when there are close to 3 million new foreclosure filings annually. New foreclosure filings peaked in 2010 and it is clear the worst is behind us…but having the worst behind you doesn’t mean you don’t still have “bad” in front of you.
Though the U.S. has an unemployment rate of 9%, the rate of unemployment for young workers is much higher. We saw governments overthrown in North Africa (and it wasn’t OLD people doing the overthrowing). We have seen increased civil unrest in the Middle East.
Now there are riots in London…and it’s not the old people doing the rioting. Great Britain instituted austerity measures to reduce the deficit, taking money from public spending over the next four years. That apparently didn’t set well with the youth who are already experiencing high unemployment.
If the U.S. falls into another recession and unemployment ratchets upward again, look for the Fed to embark on QE3 (the 3rd round of Quantitative Easing) and for the Obama Administration to make another attempt at fiscal stimulus. Governments everywhere dislike civil unrest and civil unrest usually comes down to one thing: jobs. If you have a job, you don’t have time to demonstrate. If you don’t have one, you have time to demonstrate…all you need is unemployed buddies to help make your demonstration meaningful. Then it helps to have Facebook and Twitter so everyone knows where the demonstration is…or where the riots are.
Obama definitely does not want that happening during an election year.
The stock market declined over 2% in July, bringing its YTD return to just under 4%. Of course that was completely wiped out in the first week in August. Here’s an interesting statistic: if you had your money in the S&P 500 Index (assuming no costs or fees at all), from December 31, 1999 through August 8th, your annual return is close to 0%. ZERO. NADA. Eleven years, 7 months and 8 days…no return. Most investors probably did worse than that, as they tend to panic at market bottoms (and get out at the wrong time) and get euphoric at market tops (and get in at the wrong time).
Earlier this year we said we had been investing in municipal bonds. And not just municipal bonds, but zero-coupon municipal bonds, the most volatile type. And not just zero-coupon…most of the bonds in which we invested are municipalities in California. It seems there was a period of time in 2010 that investors decided to invest “anywhere but California.” The prices on some bonds got so cheap, we were looking at tax-free rates of return in excess of 7-½%.
That investment call has done well so far. I mention it because the stock market is starting to remind me of the California Municipal Bond market. I don’t think I’ve written an Investment Commentary in the past 4 years in which I said I might start getting excited about buying stocks. The past two weeks have pushed the prices of many companies to very attractive levels. At Boyer & Corporon Wealth Management, we will be looking to increase our equity allocation.
That doesn’t mean the stock market won’t fall further. The pendulum frequently swings too far in both directions. As gloomy as things appear to be at times (and there are plenty of reasons to see the gloom), there are a few good things:
- The U.S. economy is still growing (at least today)
- Oil has declined 20% since the beginning of June. The eventual drop in prices at the pump will have the effect of a tax cut, putting more dollars in the pockets of consumers and increasing consumer demand.
- Money is cheap and the Fed will work to keep it that way
- New jobs are being created every month. Not enough to bring down unemployment but in 2008, jobs were being CUT every month.
- Unemployment claims have declined
- Next year is an election year. The Obama Administration will be pulling out all the stops to make things better…if that’s possible.
One more thing…Quit watching TV.
~Richard W. Boyer, CFP, CFA
Chief Investment Officer
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.