Damned if you do; damned if you don’t. What to do about the crisis over the debt ceiling negotiations in Washington? If the Government cuts spending too much, fiscal drag will slow the economy further and corporate earnings will suffer. If it does not cut enough, it becomes increasingly likely that the credit rating agencies will reduce the AAA rating that the US has enjoyed for almost 100 years. Since neither political party wants the US to default on any of its obligations, it is likely that a compromise will be reached but will not achieve the $4 trillion multi-year spending reduction that Moody’s has voiced as its marker to avoid a reduced credit rating. Having been late to recognize the serious credit issues surrounding subprime lending, it is ironic that the rating agencies have only noticed the US debt problem once both political parties have agreed that spending has to come down.
As the grand experiment in large fiscal and monetary stimulus comes to a quiet close – quiet because the US will continue to run budget deficits for some time to come and there is no sign the Federal Reserve will be unwinding its balance sheet any time soon – it remains to be seen how US politicians will coalesce around a meaningful plan to restore a more healthy debt/ GDP ratio than the bipartisan Congressional Budget Office currently projects. The lack of political consensus in Europe in handling the Greek crisis is not a model US policy makers should emulate. By providing additional funds and postponing debt write-offs, the inevitable Greek default will be more severe, with wide ramifications for other countries and European banks.
Policy makers on both continents now have constraints on their ability to extend economic cycles. New fiscal stimulus packages will not be forthcoming. Until interest rates normalize, the Federal Reserve has no flexibility to reduce them. With slow growth now endemic, risks abound. Corporations will likely continue their practice of maintaining high levels of cash on their balance sheets. Consumers, too, will likely do what they can to improve their personal balance sheets.
In this kind of environment, investors are likely to favor companies with reliable earnings. We use rising dividends as an initial metric in identifying attractive investment opportunities. The eroding dollar has helped support the earnings of US based multinationals. While we do not advocate a weak dollar (it penalizes consumers), we also look for companies with significant overseas exposure.
Short of a meaningful budget resolution out of Congress, which would provide the market with a psychological boost, we do not expect any significant fallout from the debt ceiling negotiations. Should the credit rating of the US fall to AA, interest rates will probably not be affected meaningfully. However, we do expect a global economic slowdown, unrelated to the debt ceiling issue, with broad investment implications. We are also concerned that earnings expectations for the third quarter seem aggressive. Analysts seem to be projecting increasing revenues and margins consistent with the early phase of an economic recovery. Any kind of disappointment will increase uncertainty and market volatility. The stock market will likely end the year close to where it is today. The good news is that corporations should continue to buy back stock and increase their dividends to reward and attract investors.