Heat Wave of Summer Politics

Eric Linser, CFA | July 29, 2011

It's a hot, hot summer. Or at least others tell me so. Having lived in San Francisco for the last 15 years I've accepted that 68^o is a hot day here. It seems the rest of the country is scorching. In some cases, record-breaking heat waves.

The heat that's enveloping the country appears to be hot stagnant air coming out of Washington DC. It's stymieing all of America. Every time I see the President on TV he's pretty heated. No matter where you live, everyone seems heated about the absurdities taking place in the Capitol.

"Debt ceiling" is the buzz word of the day. If you're like me, you're sick of the political grandstanding and acrimony. This is not a time for ideological battles, but of compromise. I like most Americans abhor extremes and mistrust ideology that borders on outright stupidity. That goes for all of them -- democrats, republicans and tea partiers alike. If you can't stand the heat, get out of politics. If you're unwilling to compromise, don't go into politics in the first place.

Who wins? No one! But the losses are adding up, particularly for the US economy and job seekers. At a time when there should be some fiscal stimulus to get people fully employed, the stupidity in DC is driving the car (that is the US economy) back off the road and into a ditch. This is particularly impactful as the US economy depends on its citizens’ consumption for 70% of its GDP, and 85% of the government’s revenue comes from personal income taxes and payroll taxes.

The economy isn’t growing fast enough to absorb the large number of Americans looking for work. And now we’re seeing a step-up in lay-offs yet again. While sales at many companies have come back (and quite strongly for some) from pre-recession levels, jobs haven’t. Corporate investment is underpinned by confidence or the lack thereof. If employers are worried the economy is rolling over or that government red tape will hamper their business, they will forgo making investments and creating jobs. No one is immune, except maybe those that are deaf, dumb and blind in Congress.

Will the US default on its debt?

No. The US will not miss any coupon payments on its $14.3 trillion debt. The debt ceiling will be raised, even if its an end-run by the President to hide behind the 14^th Amendment of the Constitution which states the “validity of the public debt of the United States shall not be questioned.” By the time the Supreme Court decides to answer the ambiguity of that Amendment, a short-term solution will be in place.

Whatever deal is cobbled together over the weekend, I don’t believe it will be a credible deficit reduction plan. That probably won’t happen until the 2012 Presidential election takes place.

Will a downgrade of the US sovereign rating of “AAA” by the credit rating agencies mean higher interest rates?

No, not yet. Once the economy is out of intensive care then we can circle back on that. Interest rates on mortgages, credit cards and other loans aren’t going to reset higher after August 2^nd. You’re better off worrying about inflation and higher food, energy, and heath care costs; that’s what’s eating a hole in your wallet.

A downgrade of US debt is only a sideshow right now. US Treasury debt investors have taken the increasing threats of a downgrade, and possibly default, in stride. There has been no big spike upwards in yields demanded; no 10% or 20% interest rates as seen in the PIIG countries.

In light of all the fear out there of the federal government’s problems the yield on 10 year Treasuries has dropped by 0.75% since April and is hovering around 3%, so no one seems to be buying that the US won’t pay its creditors on time.

10 year Treasury Yields (constant maturities) - 5 year chart through June 27, 2011
Source: Federal Reserve Bank of St. Louis

In the near term, it’s risk aversion, fears of growing European debt problems, and a weak domestic recovery that’s bound to keep US interest rates low for the foreseeable future.

Since springtime, global economic growth has been slowing as a result of rising commodity and energy prices, tighter monetary policies in developing countries, and disruptions to the global supply chain due to Japan’s earthquake.

How about the stock market? Stay the course or get out?

First, you should look to have money set aside to cover 1-2 years of living expenses. Only then should investments be made in “risk assets” such as stocks.

In the short term, stock movements hinge on the outcome of getting a debt deal done; it’s that simple.

Within the capital markets, investors’ responses have been somewhat muted to the debt deal wrangling. There are no signs of panic in the bond market; now we need the stock market to see the issue the same way. The Dow Jones Industrial Average has declined by 4% or ~ 600 points over the past week as stock investors voice their displeasure by dumping shares. For the month of July, the Dow is down ~ 2%.

For perspective, let’s look back a couple of months. From the US market’s high of late April to mid-June, the Dow declined 7% or ~ 900 points because Greece was tottering on the brink of default. What happened then? Lo and behold, the Dow rallied by 800 points. Stocks will rally again on the back of healthy corporate profits and resolution to the short-term political impasse.

Technically speaking it looks like the Dow could revisit its June low of 11,860. This pull-back offers panic driven buying opportunities to patient investors. “Buying low and selling high” means stepping in when things look bleak.

That’s what Ben Bernanke does – he steps in when things look bleak. And given the lunacy in Congress right now he’s changing into his “Captain America” cape ready to launch QE3. While monetary stimulus might not be the right answer, it’s the only one we’ve got right now. Look to market inspiring words from Ben at his Jackson Hole meeting in August.

There will be no financial Armageddon that’s being bandied about in the press. The media is great at fear-mongering, particularly in Rupert Murdoch’s media empire. Sometimes the best thing you can do is put down the remote and turn off your TV.

Heated summer rhetoric in DC will cool (as much as it can before the big election year of 2012), and we should see cooler heads prevail. And I want you to stay cool as well; it is essential for investment success to stay disciplined and focus on the issues that matter in the long run and not to get sucked into the headlines of doom and gloom.

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