The Debt Ceiling is Stupid

What is the debt ceiling?  It’s a relatively arbitrary limit set by Congress on how much debt the government can issue.  It’s a big deal now because the debt ceiling must be raised in order for the US government to meet its obligations and borrow more funds in the bond market.

If the debt ceiling isn’t raised, some or all of the following will happen:

• Government employees stop getting paid
• Government services are stopped
• Projects go on hold
• Interest payments aren’t made on current debt (US defaults)

The severity of each outcome remains to be seen.  The order in which this would occur is an uncertainty, with the exception of the interest payments on US issued debt. Despite what the press says, this will not lead to an immediate default on US debt, but debt payments would be made at the expense of the government salaries, services, and entitlements. At the very least our debt instruments would be downgraded by the rating agencies, because of the failure to pay and the uncertainty of payment.

Regardless I don’t think anyone could argue this would be a good thing given our current environment.  Any of these would further weaken the already weakening macro data (e.g. unemployment, manufacturing indexes, etc.) and certainly not be good for stocks. Of course if the interest payments aren’t made this could open up a whole new set of problems, mainly rising interest rates caused by a lack of confidence in the United States to pay their obligations.   The 30 day Treasury has long been used as a proxy for the risk-free rate of interest. 

Most commentators think this is going to happen and the market, while volatile, doesn’t appear to be signifying the debt ceiling won’t be raised.  That said, Congress seems to be full of idiots/ideologues so anything is possible and the longer it goes on the more uncertainty there will be in the market.

Trading or Investing?

Recently PIMCO disclosed their holdings, which indicated they increased their Treasury bond holdings.  This seems to be in direct conflict from months earlier when they reduced their Treasury bond holdings.  In fact, PIMCO chief Bill Gross’ public media statements resulted in a few clients calling wanting to blow out of Treasuries because PIMCO was.

A Portfolio Manager manages according to the requirements of their offering documents or prospectus.  They are able to buy and sell what they want when they feel it is best for the portfolio in accordance with those governing documents. 

What’s the point?  Just because an investment manager is screaming at the top of his or her lungs to enter or exit a position doesn’t mean you have to.  Many of these managers turn over their portfolio 2 or 3 times a year.   Thus, what they hate one month may be their biggest trade the next.  They are trading to profit from a spread. If you chase them, you risk being behind the curve, and may only wind up chasing your tail.

The key takeaway is this: if you are investing for the long haul you shouldn’t necessarily worry when a trader is getting in or getting out.  Just because a trader is exiting a position now doesn’t mean that position is a bad investment, it just means that trader thinks somewhere down the road there might be a better entry point.  Those investors who try to mimic traders seldom have the information necessary to make a good decision.

I suspect many investors who followed the tailwind of major portfolio managers and news reports will discover that they are not better off than those who followed their original investment discipline. 

Why the US Doesn’t Have the Same Issues as the Eurozone

As a follow up to my previous post on the Eurozone, I will now attempt to explain is why the US is different than the Eurozone.  Again, I am going to use a very basic example:

1. Country US and Country Emerging have different currencies.
2. Country US and Country Emerging borrow at different rates given that they have independent central banks and their currencies fluctuate freely in the market. 
3. Country US borrows money from Country Emerging; however, it borrows in its own currency.  This makes Country US’s currency depreciate in value.
4. Country Emerging wakes up one day and realizes this is lunacy and stops funding to Country US’s private sector.  This presents a problem, as Country US’s growth is dependent on this funding.
5. Given Country US has a different currency than Country Emerging they print money and inflate/devalue their currency, increase competitiveness, and boost exports, which reduce the debt burden and help growth.
6. To further ease the slowdown, Country US’s government spends money in order to keep growth from plummeting.  Given they print their own currency and have debt denominated in their own currency, they are not dependent on Country Emerging to fund their government.  Thus, they can continue to borrow.
7. As a result, Country US has the ability to increase government spending, helping the economy grow or at least hamper the slowdown.

The Eurozone Problem – A Three Minute Lesson

This is an incredibly difficult topic to understand. Cullen Roche presents it succinctly here; however, for this post I am going to use a very basic example and really simplify this complicated issue down:

1. Country ABC and Country XYZ have the same currency, but broadly speaking, Country XYZ is a more risky place to invest. 
2. Given that they share the same currency and central bank, when things are good Country XYZ can borrow at the same low interest rate as Country ABC. 
3. Because Country XYZ is more risky, the private sector takes on more debt (if you should be borrowing at 7% and you can borrow at 2%, you borrow more), which is often lent to them by Country ABC.
4. Country ABC wakes up one day and realizes this is lunacy and stops funding to Country XYZ’s private sector.  This presents a problem as Country XYZ’s growth is dependent on this funding.
5. Given Country XYZ shares the same currency as Country ABC they can’t inflate/devalue their currency, increase competitiveness, and boost exports, which would reduce the debt burden and help growth.
6. As a result Country XYZ must have the government spend money in order to keep growth from plummeting.  However, given they don’t print their own currency they are dependent on Country ABC to fund their government.
7. Country ABC won’t fund Country XYZ’s government given the massive drop off in growth and high debt burden.
8. Country XYZ has to cut government spending, reducing growth further and creating a vicious cycle.
9. Country XYZ may have to leave the currency, devalue, default, and suffer a lot of pain before ultimately recovering or…
10. Continue to cut spending, stay in the currency, and have a drawn out stage of low/negative growth.

In my next post I will compare and contrast the Eurozone with the US.  Here’s a hint: while we have our own problems, at least we don’t have these.

Inflation? Not Sold Yet

With gas prices high and food prices rising, many people are feeling the squeeze.  This begs the question: Is inflation a concern?  I say no, not yet at least, and the chart from the St. Louis Fed (via the Pragmatic Capitalist) illustrates why:

As the chart shows, essentially all prices outside gasoline are staying relatively flat.  While there has been a modest uptick as of late, as Paul Krugman points out, inflation is still way below trend. 

That isn’t to say inflation won’t eventually be a problem.  In fact, I have seen charts, given the recent move up, that demonstrate there could be higher inflation in the near future.  Still, given the small uptick in inflation, high unemployment, and lack of credit moving through the system, inflation should be relatively tame and I certainly assuage only a very small probability to hyperinflation.

Gold’s Value?

I was alerted to this MarketWatch article on Gold, which raised many of the issues I have with the precious metal:

• We aren’t near a real high.  That was around $4,000, about 30 years ago.  Today, Gold hovers a little over $1,500.
• If Gold is a pure inflation hedge, why did it lose value in real terms over the last 30 years?
• The U.S. Dollar (USD) seems nowhere near collapse or to the point where it loses its status as the primary medium of exchange any time soon.
• Despite the rise in commodity prices, many aspects of the economy are still deflating (e.g. housing).
• While not perfect, the USD is still the best currency around.  
• Gold tends to do well in periods of uncertainty; however, if you take that to the endgame – a complete collapse of government – will gold still have value?  I would rather have gasoline, water, ammo, or canned food.

None of the above comments are meant to infer Gold can’t move higher, in fact when compared to its previous bubble Gold still has room to run.  That being said, the idea that Gold will soon replace the USD as the way we exchange goods and services or that it will even be a perfect hedge against the USD appears to fly in the face of logic and history.  

It’s All About You

As I was reading this article I couldn’t help but think of investor envy.

The writer describes his life as a trader.  He was fairly successful in an absolute sense, but relative to his peers he began to lag.  This was so frustrating that he eventually reached the point where he “only paid attention to one metric – relative performance”.  He then goes on to assert how viewing success through the relative return mindset was a recipe for failure. 

In many ways this parallels how investors feel when their neighbor puts up higher returns than they do.  The question many investors ask themselves is “why am I not generating returns that high?”

That is the wrong question to ask.  Maybe the neighbor has a huge position in one security or is heavily allocated to risky assets or has leveraged up the portfolio or maybe he or she is just a fantastic tactical trader.  Regardless of the answer, the reality is the how/why is totally irrelevant.  Investors need to focus on their goals and objectives. 

Further, investors should be more concerned about risk.  Before considering gaudy return projections sit down and think:  what can you lose and is it worth it? 

As an investor that is how you have success in the long-run, avoid excessive risk taking, and sleep easy. 

The Yield Curve, a Positive for Stocks

The US has the steepest yield curve in the world according to Richard Bernstein (per Pragmatic Capitalist).

This has historically been a good thing for stocks.  Why?  A steep yield curve is when short-term interest rates are lower than long-term interest rates, which gives financial intermediaries incentive to lend, pumping funds into the economy.

On the flip side, you have the inverted yield curve.  This is when short-term interest rates are higher than long-term interest rates, which discourages financial intermediaries to lend (why borrow at 5% to lend at 6%?) and is an indication that credit is drying up (cash is hoarded and not lent out).

This brings 3 caveats to mind:

1. The yield curve is being distorted by the Fed.
2. Banks still aren’t lending.
3. As Bernstein notes, many emerging countries (India and Brazil) are close to having an inverted yield curve, which is usually indicative of an economic slowdown.  If those emerging countries do slow that could have a negative impact here.

Still, on the margin I go with a positive, despite the above caveats.  History has been a pretty good guide when it comes to the yield curve; however, it isn’t the clear cut “buy now” indicator it has been in the past.

Greek Follow Up

So Greece passed an austerity package and it appears that they will get a bailout from Germany and France.  I expressed my concern in the past about the perils of a Greek default and now that it is “resolved”, I feel a quick follow-up is necessary.

I get the sense from my readings that this won’t solve anything long-term.  The problem still exists (Greece can’t pay back their debt) and has probably been pushed down the road. 

At the same time, the situation in Greece seems to be getting more combustible.  I do wonder if (maybe when?) more cuts are needed down the road how the people will react.  Will the government be thrown out, making default inevitable?

That said, the delay does give holders of Greek debt more time to adjust their positions, strengthen their capital base, and hedge accordingly.  Basically, a slow moving train wreck is better than a quick one in this instance (e.g. 2008).  It should contain the damage I outlined in my previous posts (linked above); “should” being the key word in that sentence.   Maybe I am being too optimistic. 

Time will tell on this.  For now, this is a positive. 

Spending? Yes Please

Bill Gross is one of the best bond managers around, so it’s always comforting when someone as astute as Gross is on the same page as you.  In a prospectus for his clients (via TPM), Gross said:

“Solutions from policymakers on the right or left, however, seem focused almost exclusively on rectifying or reducing our budget deficit as a panacea… Both, however, somewhat mystifyingly, believe that balancing the budget will magically produce 20 million jobs over the next 10 years.”

In a previous post I highlighted my concern with spending cuts in regard to the market.  Broadly speaking, with the consumer being over leveraged and unemployment still high, where is the incentive for the private sector to invest? 

My concern is that if government doesn’t continue to spend the private sector can’t and won’t pick up the slack.  Further, if the government stops spending, how does that help the economy now?  I have difficulty finding the logic in that argument. 

Gross has a solution:

“Government must step up to the plate, as it should have in early 2009. An infrastructure bank to fund badly needed reconstruction projects is a commonly accepted idea, despite the limitations of the original "shovel-ready" stimulus program in 2009."

That seems good to me – put people to work, build critical stuff we need, employee people to do it, stimulus is pumped directly into where we need it, and the infusion gets the economy to the point where it is self-reinforcing.

Quick point, fiscal stimulus – cash injected to directly into the economy – is different than QE – where cash goes to fuel speculation.  I vote for the former and against the latter.

More QE is not the Way to Go

Here is a good video on further monetary stimulus on courtesy of Bloomberg:

In the video Lena Komileva, global head of G-10 strategy at Brown Brothers Harriman & Co., discusses why QE3 wouldn’t be a prudent move for the Fed.

First, quantitative easing (QE) is when the Fed buys longer dated Treasuries in an attempt to drive interest rates lower and inject cash onto bank balance sheets.  Both should encourage lending.  QE3 would be the third time the Fed has done this.

The problem is QE2 didn’t accomplish its stated goals: banks actually lent less to consumers and Treasury yields even rose after the November 2010 announcement (Note: the idea was floated in August 2010). 

That isn’t to say QE2 had no impact.  In fact, I believe QE2 helped raise equity prices, and despite recent volatility, the equity markets are up since the Fed began QE.  That said commodity prices are also up.  With high unemployment and a consumer, who is still deleveraging, rising commodity prices help hold back the recovery.

In a later post I will cover why QE as a policy that struggles to gain positive traction, at least in its stated objectives, but for now I just wanted to relay point out why further QE is probably not what the economy needs.