As the August 2nd deadline to raise the US debt ceiling approaches, there is little sign of politicians coming to agreement. Failure to do so would cause the US government to default on a number of obligations, a downgrade of credit quality from AAA to AA and would have a number of effects on the global economy and financial markets.

The continued posturing of politicians in regard to the debt ceiling is holding the economy and financial markets hostage. Though we are discouraged by this lack of progress, we speculate that, in the end, an agreement

will be made prior to the deadline. Though such an agreement will be a relief to citizens and financial markets, the risk of a downgrade in US credit quality later in the year or in 2012 remains unless the US government can collectively propose a significant debt reduction package in the immediate future. Given the inability for politicians to agree on anything recently leads us to have little faith that a serious debt reduction bill can be accomplished, ultimately causing credit rating agencies to downgrade the US credit status. However, it is possible that such an agreement can be made in which case rating agencies would leave our country’s credit status at its current AAA rating. Either scenario has a number of important implications for investors.

Implications of Lower Credit Rating — Not good
A reduction in credit status will likely cause an abrupt increase in US interest rates as foreign investors will demand higher returns for the higher perceived risk. This in turn will slow US economic growth from its already tepid pace and increase the likelihood of an economic recession. Economically sensitive stocks such as industrial, financial and technology shares would fare quite poorly in this environment. Given these potential risks, our team is tending to our risk management tools more than ever, through your portfolio’s allocation to stocks, sector management and carefully placed stop loss orders. Bond prices would initially decline, however rising interest rates would finally present investors with more attractive yields.

Implications of Credit Rating Left Unchanged — Not bad
If US credit quality is not reduced, the current economic expansion should continue, albeit at a slow pace. A serious and effective debt reduction package would include a number of debt service initiatives that ultimately will put a drag on US economic growth. As we suggested in our last update, this climate can be good for stock prices particularly for those companies that do not require strong growth for profitability, such as consumer staple, healthcare and utility companies. Foreign stock markets with stronger growth will also provide great opportunities in this scenario and, as always, we will be actively investing in these regions. In this scenario stock prices should outperform bonds and money market funds.

It is impossible to know which way these events will unfold. However, we are prepared for both possibilities and will be monitoring these developments closely on your behalf. Let us all hope — or pray — that collectively the US government can do the right thing in a timely manner.

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