After weeks of listening to politicians emphasize the grave nature of our nation’s deficit, they put together and signed a deal that for all intents and purposes falls short of expectations. Most importantly, the deal as signed does not pay down the deficit within a reasonable time frame, which now leads to the possibility of US debt being downgraded from its current AAA status. Stock prices tumbled again as investors began to digest this news. Keep in mind that the recent decline in stock prices, though swift, has been about 8%, within the range of a normal market correction. We believe that the recent events have a few important implications for investors.
First and foremost, the approved deficit plan will reduce fiscal spending, which will in turn slow US economic growth. Given today’s already slow growing economic expansion, this may bring US economic growth to a halt or potentially to a recession. Our work, and that of our research partners, does not yet suggest that a recession is at hand, however the risks of such a possibility have been enhanced. As we have mentioned in past writings, a slower growing economy can still be good for stocks, particularly in sectors such as consumer staples, healthcare and select technology shares which represent companies that make profits regardless of the pace of economic growth. However, a slow economy does not bode well for economically sensitive companies such as the industrial sector (you may have noticed that we have been reducing this part of your portfolio). An economy that slows to a halt and then tips into recession is not good for stock prices and can turn a short term correction (what we have recently experienced) into a longer term significant decline (what we want to avoid). Given that the risk of recession has increased, we have been, and will be, reducing your stock exposure to mitigate the risk of this possibility. In addition, keep in mind that we are global investors - many of your foreign companies will likely thrive regardless of problems here in the US.
The likelihood of the US losing its AAA credit status has also increased. As of this writing, Moody’s Investor Services, one of the largest credit rating agencies, has announced that though they are maintaining the AAA status, they have moved the US to a “negative watch”, which is what usually happens prior to a downgrade. The implications of a US credit downgrade are uncertain, but one can assume a number of outcomes. The first is an abrupt rise in US interest rates as investors demand more yield for perceived greater risk (good for those of us that want to get better value in the bond market). The second effect of a credit downgrade is the potential for stocks to fall further in reaction to this news, some of which would be purely psychological but nevertheless unwelcome. We think this is another reason to have less stock exposure.
The most obvious fix for the US economy and financial markets lies with the Federal Reserve. It is quite possible that in the coming days or weeks, Fed officials may announce another round of easy monetary policy or language that extends the recent policy of injecting money into the financial system. Though this would be welcome and helpful and likely cause markets to reverse course, the Fed does not have a lot more room to make such efforts and will likely be very careful of when they take action.
Ultimately, our nation is finally coming to grips with what has been a growing problem (no pun intended) and today marks the first step in finding a solution. We believe there will be further steps taken in the near future which will ultimately change our nation’s course back to productivity and securing our place as a world leader. Until then, we will have to meet and adapt to these challenges not only as citizens, but as investors.
We hope this update finds you well. If you have any questions or would like to meet to review your portfolio, or if anything has changed about your financial situation, please contact us at your earliest convenience.
Sincerely,
James E. Demmert
Managing Partner