The Debt Ceiling and Your Portfolio

The government shutdown has gotten most of the press coverage so far, but there is a related and bigger issue pending in the next couple of weeks: the debt ceiling. Although the federal government has partially shut down, it continues to spend money on many items. Normal government financing requires regular additional borrowing, as we typically spend more than we take in.

A closer look at the debt ceiling

The U.S. government operates subject to a legal limit—the debt ceiling—on how much overall debt can be issued. In order to increase the limit, Congress must authorize the raise. Until 2011, this was regularly done, albeit with a certain amount of protest and commentary. In 2011, for the first time, Congress refused to authorize raising the limit until after the Treasury had hit it, causing fear that the government would actually run out of cash. Ultimately, of course, Congress did approve an increase, but not until the stock market and economic confidence had taken a hit.

Since hitting the debt ceiling in May, the government has been using the “usual extraordinary measures”—such as giving IOUs to government-employee retirement funds—to find money to pay the bills. These measures are expected to run out in mid-October, leaving insufficient cash to fulfill all of the government’s obligations and forcing the Treasury to choose who gets paid and who doesn’t.

The key points

There are two critical points to keep in mind here. First, all obligations will ultimately be paid. This is a political crisis, not an economic or fiscal one, and the real risk associated with U.S. government obligations remains the same as always—essentially zero. There’s a reason U.S. Treasury interest rates are treated as the “risk-free rate.”

Second, even though obligations will ultimately be paid, the short-term uncertainty created by the debt ceiling debate has made that risk-free rate materially less risk-free than before—at least in the eyes of markets. Short-term interest rates on Treasury bills have spiked, although they remain at low absolute levels. Default swaps on U.S. debt have increased materially in price. No one expects the U.S. to default, but investors aren’t quite as confident as they have been.

What does this mean for portfolios?

On a long-term basis, the effects should be limited to slightly higher longer-term interest rates and slower growth. From a long-term perspective, this will be a negative, but no more so than other factors, requiring more adjustment of our expectations than of our portfolios.

On a shorter-term basis, the effects could be more marked. In 2011, the last time we came close to hitting the debt ceiling, the S&P 500 dropped about 16 percent. We have seen some downward movements in the market that suggest worry is starting to affect trading, and the potential for a market correction as we move closer to the debt ceiling cannot be ignored. For anyone really worried about the impact, it may be appropriate to reexamine your portfolio as a whole and reduce your overall risk. At the same time, it’s possible that any correction could actually be a buying opportunity, assuming underlying economic fundamentals do not deteriorate.

The debt ceiling debate is an example of an event that could have significant short-term effects, with relatively little effect in the long term. With that in mind, we recommend riding out any short-term turbulence and sticking to a disciplined investment strategy.

If you have questions or concerns, please don’t hesitate to contact us at 509-664-8844 or at Info@TelosWealth.com.

Sean Gross, CFP®, AIF® | Co-Founder & CEO

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All indices are unmanaged, and investors cannot invest directly in an index. Past performance is no guarantee of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved. 

Sean Gross, CFP®, AIF® is the Co-Founder and CEO of Telos Wealth Management, LLC, a Registered Investment Adviser located at 656 North Miller St., Wenatchee, WA. Sean can be reached at 509-664-8844 or at Info@TelosWealth.com.

Client Letter, Fall 2012

The true theory of our Constitution is surely the wisest and best, that the States are independent as to everything within themselves, and united as to everything respecting foreign nations. Let the general government be reduced to foreign concerns only, and let our affairs be disentangled from those of all other nations, except as to commerce, which the merchants will manage the better the more they are left free to manage for themselves, and our general government may be reduced to a very simple organization and a very unexpensive one…” — Letter from Thomas Jefferson to Gideon Granger, August 13, 1800.

Current Market Environment

Our Market Environment Indicator (MEI) remains "bullish" (i.e., risk-on). As a result, in accounts employing our Market Leaders Model Portfolio (MLMP) investment strategy, we’re currently overweight equities and underweight bonds and cash. In spite of our rather pessimistic economic outlook, the market may have additional upside left: we are currently in the early stage of the historically best-performing period of market performance, October through April. While we do think there is another correction on the near to intermediate-term horizon, we are not yet “bearish”, and will continue to rely upon the MEI to signal when it’s time to position accounts employing our MLMP strategy more conservatively.

Unfortunately, we remain of the opinion that any near-term positive market performance is not likely to be based upon broad improvement in the macroeconomic picture, but rather upon expectations that “QE3” will be successful in inflating capital asset prices. Central bank activism can only postpone—not avoid—the ultimate day of reckoning for an economy trapped in a debt deleveraging cycle. Case in point: the Japanese central bank recently embarked on their eighth round of quantitative easing since 2000. In order to determine how effective their "QE" programs have been, one only need look at the Japanese stock market as measured by the Nikkei index: it was at 13,500 at the end of 2000 and it’s at 8,947 today—over 33% lower!

The path to higher risk-adjusted returns, and the ability to avoid large losses, is particularly difficult in the current market environment where zero-percent interest rates are grossly distorting the value of capital assets. Intermediate and longer-term risks will remain high until there is a fundamental change in how global governments and central banks deal with the unprecedented debt crisis they are facing. In the meantime, we believe there will continue to be cyclical investment opportunities which can be taken advantage of through both risk-on/risk-off and absolute return investment strategies.

Unintended Consequences?

We recently received this email from a business owner: “…last week I found our medical insurance rates will rise 50-75% next year to account for the changes required by the “Affordable Care Act.” My personal rate went up almost 100% this year as insurance companies are shifting policies in anticipation of losing younger participants. Furthermore, I heard from my Uncle and he found the “Affordable Care Act” has caused him to lose his Medicare Advantage coverage and will result in an additional $250 a month in costs.”

Whether or not you are a business owner, the broader financial impact of this real-life example should not be ignored. It goes without saying that if businesses have to spend more on health insurance it will have a negative impact on their revenue. If revenues go down, the amount of money companies have to pay for wages and other benefits will go down, as well, possibly putting further pressure on the unemployment rate.

While the unemployment rate recently fell to 7.8%, it is still almost 3% higher than what is typical for an economy heading into its fourth year of recovery—a recovery built primarily on unprecedented fiscal and monetary stimulus.  On the fiscal stimulus side of the ledger, the objective of our government has been to replace private sector spending—which is depressed due to the stubbornly high unemployment rate—with public spending. On the monetary stimulus side of the ledger, the objective of our Central Bank has been to make money less expensive to borrow. However, there is little evidence to suggest that this type of stimulus and spending have been effective over longer periods.^[i]

The Fiscal Cliff

There are multiple components to the so-called “fiscal cliff” which, combined together, present a very serious economic and political problem for the U.S. To help illustrate the personal income tax components of this complex issue, we have attached a fiscal cliff graphic summary provided by Principal Funds (also available here: https://secure02.principal.com/publicvsupply/GetFile?fm=MM5925&ty=VOP&EXT=.VOP). From a purely income tax standpoint, if Congress allows the Bush-era tax cuts to expire, personal income tax rates are scheduled to increase from 10 to 35% in 2013. For investors, capital gains rates are scheduled to increase from 15 to 20%. With this in mind, we strongly encourage you to discuss your personal situation with your tax professional and financial advisor.

U.S. Elections

I recently spoke to a young man who said to me, “I’m so fed-up with the bitterness of the presidential election that I’m not going to vote.” My encouragement to this young man was the same as I will humbly offer you, dear readers: “I completely understand your frustration, but elections have been like this since—at least—the presidential election of 1800 between John Adams and Thomas Jefferson^[ii]. So, please don’t forfeit your right to freely vote, which was secured by the blood and toil of those who have gone before us.”

When it comes to actually predicting the winner of the election, we’re not sure that the often quoted polling data can be trusted. A better gauge may come from the Michigan Consumer Sentiment Index, which measures the attitudes of consumers (http://www.conference-board.org/). According to Bloomberg^[iii], since the days of Richard Nixon every incumbent enjoying average reading of 95 or above have always been re-elected. Meanwhile, those with readings below 95 have never been re-elected. The Index now stands at 72.2, the highest since February 2008, and up from 68.4 in September.

Hurricane Sandy

This letter was completed just prior to the news regarding the devastating impact of Hurricane Sandy on the Eastern and Mid-Atlantic regions of U.S. We will address the potential economic impact of this disaster in a future letter. In the meantime, we are thankful that more lives were not lost, and we continue to pray for those who have been affected by this catastrophe.             

Sean Gross, CFP®, AIF® | Co-Founder & CEO

Sean Gross, CFP®, AIF® is the Co-Founder and CEO of Telos Wealth Management, LLC, a Registered Investment Adviser located at 656 North Miller St., Wenatchee, WA. Sean can be reached at 509-664-8844 or at Info@TelosWealth.com.

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[i] John H. Makin, The Limits of Monetary and Fiscal Policy http://www.aei.org/article/economics/fiscal-policy/the-limits-of-monetary-and-fiscal-policy/)

[ii] Richard J. Behn, The Election of 1800-1801 (http://www.lehrmaninstitute.org/history/1800.html#intro).

[iii] Michelle Jamrisko, Obama Second Term Would Defy Confidence Measure: BGOV Barometer  

(http://www.bloomberg.com/news/2012-08-30/obama-second-term-would-defy-confidence-measure-bgov-barometer.html)

Planning for Health Care Reform Surtax

To help pay for the cost of universal health care, a new federal tax will be imposed on most net investment income for those with higher incomes. Starting in 2013, higher-income taxpayers will be subject to an additional 3.80 percent tax on most net investment income. This new tax impacts taxpayers with wages or net earnings above $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately). The exceptions to the surtax are distributions from retirement accounts, including pensions, 401(k)s and IRAs, and income generated from municipal bonds.

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Client Letter, Spring 2012

Steve’s “Restylement”

For the last 4 years, my colleague Steve Bogen and I have been making preparations for his eventual retirement—that is, “restylement” (see below)—in order to ensure there was a plan in place for his clients to continue being served by TWM after his departure. That time has now come: Steve will be retiring from wealth management on 3/30/12 and restyling his life around a new vocation.

If you know Steve’s work ethic, you’ll rightly assume that he will not be retiring to an easy chair (read more…)

Also in this post: Uncharted Waters, Market Environment Indicator, Obamacare goes to Supreme Court, and Celebrating 5 years

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Retire at Work

Despite the image that marketers portray of contented retirees lounging on the beach, there are more older workers in the labor force than ever before...

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