Government shutdowns, Debt Ceilings and Austerity

The headlines grab our attention as they are designed to do.  They alert us to the debt problems facing Europe, the stalemate in Washington and the costs of a state shutdown.  We are informed of the dire consequences that could result from any of these.  It seems the political rhetoric that runs so hot around these issues was designed for this sound bite information age.  Lawmakers compete against each other like sports teams, each trying to claim a win.  This is happening in government at all levels and around the globe.  In Minnesota, the rhetoric continues past the budget deadline and the state government shut down.  Ultimately, this is costing Minnesotans millions in lost revenue and additional long term costs as the state’s bond rating has been downgraded.  Nationally, the debate about the debt ceiling goes on with parties firmly entrenched along their party lines.  Having already reached the federal debt ceiling in May, officials are now playing a game of chicken that does not have a winner. While we’re told by some that apocalypse looms, the reality is that both the eventual outcome and consequences are unknown.

In any event, planning for uncertainty becomes all the more important.  It’s no doubt that portfolios would be impacted if an agreement is not reached, however the fixed income piece of our client’s accounts have been positioned to withstand the storms.  We do this by simply keeping high-quality, short duration bonds and decreasing exposure to US government bonds.  We, along with most professional investors, believe it is an attribute to avoid knee jerk reactions.  This is the part of the portfolio that allows us to ‘wait out’ the market’s swings. While it’s our belief that the odds favor a resolution that will keep our government making its scheduled payments, the fixed income part of the portfolio makes sure you continue to get your scheduled payments.  With that said, volatility can also be an investor’s friend.  Some portfolio managers are taking advantage of volatility to buy good solid companies that are now less expensive.  However, patience is usually the key to making money during uncertain times.

Markets are often volatile and have periods of poor performance during times of uncertainty. Since the US economy officially entered ‘recovery’ more than two years ago, we might have expected to be enjoying a solid economic recovery by now.  Unfortunately, as Ben Bernanke said in his recent speech, the growth has been ‘frustratingly slow’. In fact, this recovery is moving slower than any since the 1930s.  However, we also experienced the largest recessionary decline since the Great Depression. During this most recent recession we saw real GDP decline by 4.1%.  A significant decline, but thankfully no where near the 26.7% lost from 1929 to 1933.  After two years the economy has grown at only half the pace of previous recoveries.  Instead of a sharp broad snap back, we are experiencing a few bright spots in sectors such as manufacturing and corporate profits amidst a very poor housing and employment market.  In spite of some poorly performing sectors, the US markets turned a small return for the second quarter after a solid first quarter for investors.  The S&P 500 had a three month return of .1% and 6% for the year.  The leading sectors were health care, utilities and consumer staples generating 7.9%, 6.1% and 5.3% respectively for the quarter.  Health care was also the year to date sector leader with 13.9% return.

As we go into the second half of the year, we should expect continued volatility. We still have a set of big macro-economic obstacles to overcome even though the fundamentals of many companies continue to improve.  If austerity didn’t become a part of our 2010 vocabulary it certainly should in 2011.  We must acknowledge the need for fiscal responsibility and deficit reductions, but also realize we didn’t get to our current levels of debt without working very hard at it over the past 30 years.  In this slow growth period of our economy, to make immediate and deep cuts across the board is not prudent. The handoff between business and government, while necessary for sustainable growth, is happening slowly and policies on the outer reaches of either political spectrum will not aid a smooth transition.

We understand that many individuals have concerns during these uncertain times. Our philosophy has always been not to react to news as it is happening, but instead strategically position our clients’ portfolios to take into account negative outcomes that can occur from time to time.  The real question then becomes, do we have the correct allocation that will help sustain cash flow needs during difficult times.  Our philosophy does not change based on current events in the news.  As we have mentioned in our meetings, buying time or building a cushion of bonds/cash within a portfolio for an extended number of years, preferably a minimum of three years, allows you to maintain the lifestyle you have grown accustomed to.  Most importantly, this positioning lowers the volatility in the overall portfolio.  We believe that the overall economic environment will continue to improve during these difficult times.  We encourage you to contact us with any questions or concerns that you may have.  We appreciate your continued trust and look forward to talking with you throughout the year.