Why the U.S. will never be another Greece

Greece is in the headlines recently as the interest rates on Greek government bonds have risen sharply due to their fiscal problems.  Greece is part of the European Union (EU) and the level of Greek sovereign debt as compared to GDP and the annual deficits as compared to GDP are well in excess of EU guidelines for its member countries.  Remember though the currency for Greece is the Euro, meaning Greece can't simply issue more currency to inflate their way out of their fiscal and debt problems.  There is the chance that Greece could default on its debt if it doesn't get some help from stronger European Union members like Germany.

The United States is a different story.  Since the U.S. controls its own currency, there would never be a default on a Treasury bond.  If the U.S. was in dire financial straits similar to Greece, we could (and in our opinion would) simply print more dollars to pay our fixed debt obligations.  The result, reductions in the value of the dollar as compared to other world currencies and gold accompanied by inflation.  This, we believe, is the long-term risk of excess U.S. deficits and growing debt.  For those looking several years down the road, now may be the time to begin hedging against the possibility of such inflation and dollar declines

January 2010 Market Update (Posted to our blog two weeks after sending to clients.)

If you know how to spend less than you get,

you have the philosopher’s stone.

Benjamin Franklin

As we write this on January 29th, the S&P 500 index stands down 2.6% year-to-date through January 28, 2010. Remember, the S&P 500 index was up almost 70% from its low on March 9, 2009 through December 31, 2009, so some breather was certainly in order.

Today, the Commerce Department announced that 5.7% was the “advance” GDP annualized growth rate for the U.S. economy in the 4th quarter of 2009. This rate of economic growth was well above the expectations of about 4.5%. Dr. David P. Kelly, PhD at JP Morgan has for some time argued that the cyclical recovery would be stronger than most experts were forecasting due to recoveries from deep declines in housing, autos, inventories and capital equipment- it appears he was right as to 4th quarter.

However, we believe even a stronger-than-expected cyclical recovery must be viewed in the context of the present structural challenges with which the entire world is faced. A brief summary list of such challenges reads as:

1. All economies, including the U.S. received significant stimulus in 2008 and 2009. The timing and method of removal of such stimulus, and the effect on these economies and the markets, is still unknown. China recently raised bank reserve requirements and instructed banks to slow lending, and world markets immediately fell.

2. The developed world, led by the U.S., is running huge budget deficits. While some of such deficits will go away with economic recovery (more tax collections, fewer government benefits to the disadvantaged), the projected level of future deficits at some point will threaten the economic health of many countries. A poster child for such problems today is Greece, where their total debt exceeds their GDP and a loss of market confidence has resulted in a present rate on their 10-year government bonds over 7% (note the comparable rate in the U.S. is 3.6% and Germany is 3.2%). For a moment imagine today’s U.S. economy with 7%+ interest rates—it wouldn’t be pretty.

3. The world is rebalancing from an excessive consumer in the U.S. (and some other developed countries) and an excessive saver in China and certain other countries. China is growing its domestic consumption and in a speech to the World Economic Forum yesterday, a Chinese leader pointed to 2009 domestic demand that contributed 12.5% to 2009 GDP while shrinking exports reduced their 2009 GDP by almost 4%. In the U.S. the savings rate has risen to about 5% from below zero before the economic crisis. This rebalance will take some time and it won’t be smooth.

4. Governments worldwide, including the U.S., feel the populist press to weaken their currencies to subsidize their exports, consider legislation of other protectionist measures and increase regulation/taxation of a financial sector that they had to save a year ago. None of this is particularly encouraging as to healthy economic growth.

So we have a possibly stronger than expected cyclical recovery in the context of larger structural challenges. With the daily noise emanating from these somewhat conflicting situations, it is more important than ever to have themes to guide investment decisions. Our key themes include (if it looks like we are repeating some of these from prior messages, we are):

• The next several decades would seem to favor the emerging economies of countries like China, India, Brazil and others. These countries do not have the huge budget deficits of the U.S. and other developed countries. These emerging countries also have more favorable demographics in terms of age (median age in U.S. is 37 years while median age in India is 25 years) and more opportunity for growth from lower economic levels (GDP per capita in U.S. is $47,000 while in China is $6,000).

• The U.S. dollar is in a long-term downtrend (particularly as compared to currencies of countries with healthy balance sheets, like China) primarily fueled by budget deficits. We must recognize that there can be periods of significant dollar strength in such trends, but we believe any strength will not change the long-term dollar weakness.

• Given the various challenges, future investment returns can be expected to be lower than the long-term historical averages and be accompanied by periods of above-average volatility.

So this is what we are doing as to client planning and investment portfolio management.

A majority of our clients have engaged us to perform comprehensive wealth planning. For these clients, we are doing our very best to gather proper information and update their wealth plan at least annually in order to continually measure their progress towards their financial goals. We are working to be very realistic on expected future portfolio returns assumed in these plans (well below historical averages), and we are advising clients to have more financial “cushion” to protect from future risks. Where specific planning opportunities arise (such as Roth IRA conversion), we are working with the accounting firms to develop the most appropriate recommendation given all client specifics (note Perry Moore has authored a very good 15-page white paper on Roth IRA conversions). We are always mindful that our wealth planning process is designed to increase our client’s long-term success in attainment of key life goals.

On portfolio management, we have for some months now recommended a stock portion at the low end of our Investment Policy Statement target ranges. Reflecting U.S. dollar concerns we have positions in both international stocks and international bonds. Given our view of emerging markets, we have targeted more of our international positions to emerging markets than to developed markets. To address portfolio volatility concerns we have positions in alternative assets with the goal of those alternatives helping to reduce overall portfolio ups and downs.

While the nature of our business is that we rarely do the exact right thing at the exact right time, we find value comes from trying our best to do that which improves our clients’ lives over the long-term. We work hard to keep our eye on that long-term ball.

Majority of labor union membership now works in public sector

According to a study released by the Heritage Foundation 52% of all labor union members worked for the government (http://tinyurl.com/ygunb4g).  To get an idea of how much this has changed over the past several decades, in 1973 only 17% of union membership was employed in the public sector (of course the other 83% were employed in the private sector).

Another interesting statistic is that the portion of American workforce belonging to unions has dropped from 23% in 1980 to 12.3% in 2009.  Looking into that statisic more deeply reveals that in 2009 the percentage of private sector employees in the union was at 7.2%, while the union percentage of government workers in 2009 was 37.4%.

As government at all levels is forced to cut spending to reduce budget deficits, look for plenty of conflict with the unions representing public sector employees.  The unions have already worked hard to oppose legislation for spending cuts in many states including California and Illinois (two states in real fiscal trouble).  Also, look for the unions to continue their heavy contributions to influence political decision making at every level.

U.S. Budget- Deficits as far as the eye can see

This week President Obama submitted to Congress his budget proposal for fiscal 2011 (ends September 30, 2011) through 2020.  Deficits for the 10 years average $853 billion (4.5% when expressed as a percentage of Gross Domestic Product- GDP).  U.S. national debt held by the public (meaning doesn't count debt held by other U.S. government agencies) as a percentage of GDP is projected to rise from 53% at the end of fiscal 2009  to 77% by 2020.  A web site has been established with all budget related information at http://www.gpoaccess.gov/usbudget/.

The ratio of debt to GDP is a big deal because those who buy our debt use this as a measure of risk in setting interest rates for such debt.  History is instructive here.  In 1960 debt was 46% of GDP, after declining from a high of 109% in 1946 from costs of financing WWII.  This decline continued to a low debt to GDP of 24% in 1974.  As recently as 2001 debt to GDP was 33%.  A rise to 77% in 2020 would make us a much bigger lending risk and would certainly drive interest rates higher.

The economic assumptions in the budget proposal reflect assumed 10-year Treasury interest rates (which are presently about 3.6%) averaging 4.5% in fiscal 2011 and then rising to a maximum of 5.3% over the balance of the time to 2020.  Actual interest rates could be much higher than these projections in a world where large budget deficits continue.  Higher interest rates would make reducing the budget deficit even more challenging.

No political leader of either party has put forth credible ideas of how to deal with this problem.  It takes political courage and the ability to voice why shared sacrifice now will protect future generations.  We can only hope some true leaders will step forward with some real solutions.  The longer we wait the harder the ultimate fix will be on everybody.