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Journey with DWM to
What's Next |
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Some economists say "up" and some say "down". The truth is, no one knows the future. But affluent, enlightened investors recognize that DWM strategies perform in up markets and protect in down markets. Regardless of what the future holds, with DWM, savvy investors are ready for what's next. | |
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The 11th Hour Deal | |
The immediate crisis has been averted.
The House approved the deal Monday. Today the Senate passed it and the President gave his approval on the Budget Agreement. The old debt ceiling of $14.3 trillion has now been raised by at least $2.1 trillion. This should be sufficient to serve the nation's needs until early 2013.
The ceiling will be raised as follows: the debt ceiling will first be increased by $900 billion; $400 billion immediately to stave off default and the other $500 billion to carry through February. This increase will be accompanied by a spending cut of $917 billion over the next ten years starting as of October 1, 2011. In addition, the bill creates a 12-member bipartisan committee to recommend ways of reducing future deficits by another $1.5 trillion over the coming decade- above and beyond the amounts saved as a result of the annual caps on appropriations. These savings are anticipated to be enacted by Christmas.
If Congress meets that deadline and deficit target, or votes to send a balanced-budget constitutional amendment to the states, the debt ceiling would be raised by another $1.5 trillion, or a total of $2.4 trillion. If Congress fails to take that step, then the debt ceiling extension will be increased by $1.2 trillion to the $2.1 trillion minimum amount. In that case, there would be automatic spending cuts across government, split equally between domestic and defense spending.
Overall, defense spending could be cut by almost $1 trillion of more over the next ten years. Education, transportation and Medicare payments to health care providers could be cut by a similar amount. Currently, the plan does not include any Medicare cuts to beneficiaries or any cuts to Social Security, Medicaid, veterans, and civil and military pay.
$2.1 trillion or $2.4 trillion in cuts over the next ten years sounds pretty good, but let's put this in perspective. Currently, on average, the government spends roughly $300 billion per month and takes in $200 billion in revenue. That would be like a family spending $9,000 per month and bringing in $6,000 per month. As a result, the U.S. debt has grown from $5 trillion ten years ago to $14 trillion today. $2.4 trillion in cuts over ten years is a good start, but that's "only" $20 billion a month less in spending. We've still got a long way to go.
How did we get here? A financial crisis, stock market collapse, bank bailouts, the Great Recession and a good many moments of poor judgment. Here are a few of the major lowlights:
- Federal Reserve- lowered rates to two percent for three years after the dot-com crash, causing an inflationary spiral.
- Ratings agencies- changed their model from being paid by investors to being paid by syndicators and underwriters whose investments they were rating.
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Radical deregulation- the introduction of the credit derivative and loosening of leverage rules allowed Bear Stearns, Lehman Brothers and others to expand greatly using very little capital and lots and lots of leverage. -
Lending standards- Subprime Loans, Mortgage Underwriting Standards, Automated Underwriting and the enthusiastic backing of Fannie Mae and Freddie Mac created a situation where millions of unqualified borrowers poured into the residential housing market as overleveraged buyers. -
Repeal of Glass-Steagall legislation- allowed FDIC-backed depository banks and Wall Street investment firms to become intertwined. - Congress- Both political parties are responsible for major drivers of the nation's debt over the last decade. Wars in Afghanistan and Iraq, the 2001 and 2003 Bush tax cuts and their extension in December 2010, Medicare Prescription Drug Policy and the Troubled Asset Relief Program. A Bloomberg News analysis shows these initiatives added $3.4 trillion to the nation's debt.
So, the current crisis has been averted. However, the debt ceiling is the least of our worries. Next, is the probable downgrading of US debt and after that, getting the nation's economic engine going again. In the meantime, what's the right investment strategy?
The next three articles will provide information on each. |
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The Next Crisis: A U.S. Debt Downgrade? |
 The U.S. has just avoided a debt default. Yet, it may not be able to avoid a U.S. Debt downgrade.
Both Standard & Poor's and Moody's published statements in July that the AAA/Aaa rating of U.S. Debt may be changed in the next few months, and perhaps as early as August. This could occur as Moody's stated on July 13: "If Washington hasn't reached a credible agreement to include a deficit trajectory that leads to stabilization and then decline in the ratios of federal government debt-to-GDP and debt-to-revenue beginning within the next few years."
What do you think? Is the new debt ceiling deal likely to bring about declines in the ratio of federal government debt-to-GDP and debt-to-revenue in the next few years? If our economy was growing at the rate of 5 or 6% a year, it's possible. But, with growth in the 2-3% category and annual deficits of $1 trillion or more annually expected, it's unlikely. Therefore, let's look at the consequences of a likely downgrade of U.S. Debt.
Since 1917, the U.S. has been rated AAA/Aaa. For example, Standard and Poor's currently rates 126 countries on their capacity to meet financial commitments. AAA means "extremely strong-top notch". The U.S., Canada, Germany, France, Switzerland and Australia currently have AAA ratings. A top-notch AAA rating allows a country to borrow relatively cheaply on international markets. AA means "very strong-under observation". Spain and China are now rated AA. At the other end of the spectrum, once a company goes below BBB-, they are speculative, with D being in default. Greece, which was rated CCC a month ago, has now dropped to CC.
Japan, Canada and Australia, among others, have suffered the disgrace of being downgraded from AAA. By and large, borrowing costs remained fairly steady at the time of the downgrade. It has been a different story when counties are dropped to lower ratings, such as from an A to near a speculative (or "junk") category. A U.S. downgrade would be a special case. U.S. Treasury debt is the most widely held investment, with huge chunks owned by other nations such as China and Japan.
History tells us that the key to the future is whether the downgrade prods the country to make substantial budget reforms in order to regain its AAA rating. It took Australia 17 years to restore the top rating. Japan is still at AA-.
With $14 or $15 trillion in debt, small changes in interest rates will make a big difference to the U.S. budget. An overall average increase of ¼ or 1% per year will cost the U.S., an extra $37 billion a year in interest costs, adding to the budget deficit and overall debt. If ratings continue to decline and the average interest rate increases by 1.5%, the increased cost of debt will offset the budget cuts passed this week. In addition, downgrades of U.S. debt will likely result in reduced ratings for many municipals, particularly those more heavily reliant on federal funding or backing.
Most economists and institutional investors already expect a U.S. debt downgrade. Many feel the impact is already priced into the markets. The real question is whether the U.S. can avoid further downgrades.
Our next article will discuss what needs to happen for our country to change course.
For more information: http://online.wsj/article/SB100001424053111903635604576476372332255528.html |
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The Cure: Economic Growth |
Fiscal solvency is highly sensitive to economic growth. After World War II, gross federal debt reached 122% of GDP, the highest ratio on record. In the next forty years, it fell to about 33 percent. It didn't come about by economic austerity; it was because the U.S. economy became much more robust. The same thing happened in the 90s, which began with deficits and ended with surpluses, primarily due to extraordinarily rapid growth.
But the structure of America's federal spending is much different today than in the postwar decades. In the 1950's there was no Medicare. The population was younger and American's didn't live as long.
Growth is in short supply these days. Last Friday's report that GDP grew at a mere 0.8% annual rate in the first half of 2011 suggests that the risks to the economy are still significant. This year, the four key GDP components-consumption, investment, government and trade- have all fallen short of forecasts. And, the real elephant in the room is unemployment. More than one in three jobless Americans were out of work for at least a year in a handful of U.S. states, including Illinois and South Carolina. National unemployment is still close to 10% and the small amount of new jobs created by private industry is offset by federal, state and local government cuts.
The recent political debate on the debt ceiling has managed to bring forward in a very dramatic and disorderly manner fiscal challenges that lie down the road. This political mess dealt a further blow to already-weak business and consumer confidence. Companies with massive cash holdings now have yet another excuse to stay on the sidelines. Foreigners are rethinking not only further investments in U.S. debt, but also their use of the U.S. as the global reserve currency and the location of their overseas factories.
Washington's squabbles have touched a national nerve. An increasing number of Americans are expressing deep frustration with our political process. They believe that the country deserves better and desperately needs more responsible economic governance. Thomas Friedman outlined in the New York Times on July 23rd the formation of a new "Radical Center." This is an "impressive group of frustrated Democrats, Republicans and independents, called Americans Elect." Americans Elect intend to provide a credible third choice Presidential ticket and challenge both parties with the "best ideas on how to deal with the debt, education and job."
Pimco's chief executive and co-chief investment officer, Mohammed A. El-Erian summed it up this way: "Our national leaders must use the political shambles as a catalyst for a renewed sense of common purpose and a better economic future. If this moment is not seized skillfully, the bickering of recent weeks will pale in comparison to what lies ahead as economic growth stalls further, unemployment increases, the burdens of debt and deficit worsen, income and wealth inequalities intensify, and foreigners reassess their confidence in the U.S. economy." Well said.
For more information: http://www.washingtonpost.com/opinions/after-the-ceiling-standoff-is-resolved/2011/07/27/gIQAj8JXdI_story.html |
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Ask DWM: Given the Current Situation, What is an Appropriate Investment Strategy? |
The U.S. has just averted one crisis; the debt ceiling, and may be on the verge of a new one; downgrading of the U.S. debt. Economic growth is slowing here at home and many spots across the world. Greece is close to default and other European countries are struggling financially. Yet, there continue to be solid investment opportunities both here and abroad.
We suggest that a traditional portfolio of stocks and bonds is not the answer alone; they're great during bull markets, but can be brutal during bear markets. If your first goal is to protect your assets, and your second goal to grow your assets, we suggest adding more flexibility to your portfolio. You can do so by incorporating an appropriate mix of non-correlated alternative investments. Many alternatives are designed to participate in up markets and protect in down markets. The result: less volatility, less anxiety, more consistent returns and more peace of mind.
Liquid alternatives are publicly traded securities and are easily redeemable. Some are mutual funds that follow hedge-fund like strategies, including setting "stops" and other measures to protect the downside. Others include ETFs in commodities and other asset classes. DWM uses a special model called the "DWM Liquid Alternatives Portfolio" (formerly known as "New Tactical") to gain this type of exposure.
The stock area includes long/short, market/neutral funds and/or merger arbitrage funds. Marketfield Fund (MFLDX) is a good example of a long/short fund. It can buy stocks (going "long") or sell stocks (going "short'). Its objective is to obtain capital appreciation and income as a result of the manager's performance rather than the market's ups and downs. The Arbitrage Fund (ARBFX) is a good example of a merger arbitrage fund, investing money in companies that are involved in publicly announced mergers. Its performance has little to do with the market (its "beta" or correlation to the stock market is a tiny .07), but rather is based on the skill of the managers.
The bond area may include a long/short bond fund, like Loomis Sayles's Absolute Strategies Fund (LASYX). This fund seeks to invest globally in opportunities related to credit, currencies and interest rates, while employing risk management strategies to mitigate downside risk.
Other alternative funds can be described as diversified. One good example is River North's Core Opportunity Fund (RNCOX) which is a closed- end specialty fund. RNCOX attempts to take advantage of market inefficiencies in the closed-end fund space. Their goal is to seek long-term capital appreciation and income consistent with prudent investment risk. Pimco's All Asset All Authority (PAUDX) is an example of a global tactical fund. Its goal is to seek a maximum return while employing procedures to limit the downside risk. An example of an energy fund is JP Morgan's Alerian MLP Index (AMJ) which seeks to replicate the performance of midstream energy Master Limited Partnerships.
These alternative investments are chosen to potentially complement one another and your overall portfolio. Together, they can be very powerful and excel in any environment. They require continual monitoring along with an ongoing review of the entire alternative fund universe, as new opportunities and hidden gems become available regularly.
However, let's be clear. When there is a bull market, the performance of these types of alternative investments will most likely not be as great as a 100% stock portfolio. However, in a bear market, these liquid alternative investments are geared to protect your downside. In 2008, many of these funds held their ground while equity funds suffered losses of 35% or more.
Liquid alternatives are a great way to add flexibility to your portfolio in these ever-changing economic times by participating in up markets and protecting in down markets. If you'd like to learn more about DWM Liquid Alternatives and flexibility in your portfolio, please give us a call. |
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