To our clients and friends:
Given the ongoing turmoil in the financial markets, global economies and political systems, we wanted to send you another update on our current thinking as well as actions taken in your portfolios.
Since our note last Thursday, Standard & Poor’s, one of the three major credit ratings agencies, downgraded United States Treasury debt from AAA, the highest possible rating, to AA+, citing insufficient progress towards deficit reduction in the most recent Debt Ceiling/Budget deal, as well as a dysfunctional political system that seems incapable of putting pragmatism over politics.
In addition, credit problems have continued to spread in Europe and, over the weekend, the European Central Bank announced new plans to buy troubled Spanish and Italian bonds in an effort to bring stability back into the European bond markets.
It is not clear that this new program will work. What is clear is that the European economy is slowing and the risks there, as well as here, are increasing. Confidence-inspiring political and economic leadership is in short supply and confidence, as we wrote on Thursday, is a necessary, although not sufficient ingredient for any recovery.
More importantly, the cause of the turmoil is not some short-term phenomena, but rather the large, growing and unsustainable level of debt that has been accumulated throughout the developed world, and in Europe, the U.S. and Japan in particular. This is a multi-trillion dollar problem, years in the making, with no quick easy solutions.
AA+ is the new AAA.
In the near-term, the U.S. is not suffering from a debt problem as much as a growth, leadership and confidence problem. Despite the S&P downgrade, the United States has, for the time being, no trouble borrowing to meet its obligations. In fact, in these difficult markets and following the credit downgrade, investors are flocking into Treasuries as a safe haven. Moreover, with bold and pragmatic political leadership, restructuring of sacred spending programs, tax increases, and targeted investment it is still possible to grow our way out of our problem. Possible does not equal probable, but one remains hopeful.
Europe, on the other hand is suffering from both an economic slowdown and a real debt problem. Without massive intervention by the European Central Bank, large member countries like Spain and Italy are having a harder and harder time borrowing money at affordable interest rates.
Meanwhile, across the Pacific, although Asian economies are generally in good shape, they are still dependent on Europe and the United States for a large portion of their exports and GDP growth. A slowdown in Europe and the U.S. the two largest economic zones in the world, will therefore have an adverse impact on the rest of the developed and developing world.
As events have deteriorated over past weeks we have systematically reduced risk in your portfolio. We have also made several moves to reposition investment allocations based upon our revised and considerably more guarded economic outlook.
Given how far and rapidly the stock market has fallen, it is likely that we will see a significant bounce in markets at some point soon. Perhaps even in the next few days. Some of the recent selling pressure is doubtless the result of large hedge funds and program trading systems dumping their positions.
But we have also learned over the years not to get too tricky with short-term market timing moves relative to focusing on the bigger, forward-looking picture and overall client risk management. The relevant question is whether your portfolios properly reflect the risks and opportunities as we see them today. In our view, the risks have increased significantly and we want your portfolios to be at the conservative end of their allocation ranges, with an emphasis on more defensive assets and a higher level of cash.
“The New Dismal.”
Without additional and significant monetary and fiscal intervention in Europe and the U.S. it seems quite probable to us that both the Eurozone and the U.S. could relapse into a recession, or a period of very slow-growth, higher unemployment and volatile capital markets, an environment one might call “The New Dismal.” We do not think that these probabilities have been fully reflected in the markets.
Whether these interventions will happen and whether they will be effective remains to be seen. The Federal Reserve and European Central Bank are running out of ammunition and credibility. Meanwhile, the political climate and movement towards fiscal austerity in this country and Europe makes additional fiscal stimulus programs unlikely. Finally, the increased use of Exchange Traded Funds, program and high frequency trading, and the vast amount of money flowing through the global capital markets means that we are likely to see higher than average levels of volatility.
And so our preference is to err on the side of caution and watch events unfold from a more conservative vantage, maintaining a prudent balance of high quality offensive and defensive assets, and a larger reserve of cash to deploy as opportunities present themselves.
We continue to watch the situation closely and will make additional adjustments to your portfolios as conditions merit.
As always, we are here to help and encourage you to call us if you have questions or concerns about the markets, your portfolio, or anything else.
Karl Mills, Mikel Keifer, and Bill Jurika