Deficits, Defaults, and Downgrades

Tim Phillips, CEO – Phillips & Company

There are so many interesting things going on right now in the world, but if I wrote on anything other than the debt debate it would be like talking about baseball during football season.

I still stand by my forecast that we will have a debt deal although I too am getting very worried as the decision comes down to the wire.  Although a debt deal may be reached, one unanticipated consequence of this debate will likely be an eventual downgrade of our debt rating.  (Note the use of the word eventual as it might be years)

For years, we have been racking up annual budget deficit that make up our $14.3 trillion dollar debt.

In 2007, the deficit was a mere $500 billion and now we are talking about over $1.6 trillion.

The credit rating agencies have come out and said: 

“We may lower the long-term rating on the U.S. by one or more notches into the 'AA' category in the next three months, if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.” - Standard & Poor’s

“Moody's considers the probability of a default on interest payments to be low but no longer to be de minimis. An actual default, regardless of duration, would fundamentally alter Moody's assessment of the timeliness of future payments, and an Aaa rating would likely no longer be appropriate”. - Moodys

By the way, these are the same jokers that placed Triple-A ratings on junk mortgages just a few years ago. 

The interesting thing about the debate and the reaction from the credit rating agencies is they’re not talking about our ability to pay back the debt (the $14.3 trillion). Instead, they’re talking about our ability to shrink the amount of borrowing we take on each year and our ability to refinance that debt continuously.  At the end of the day the "full faith and credit" of the United States Government is meaning a little less right now in the opinion of the credit rating mafia.  This is a sad state of affairs.

Whether we talk about paying down the debt, shrinking the deficit, refinancing our existing debt or a debt rating downgrade, we’re facing one simple fact – higher interest rates.  That's why I'm spending considerable time working on what works in a continuously rising rate environment.  You saw some of that in last week’s blog.

As we face some pretty gut wrenching days ahead with tremendous market volatility, keep your eye on the horizon which is your investable time frame.  If you have enough time, and that's relative for each of us, the volatility can be looked passed.  What can't be overlooked is the reality that we are facing the proposition of much higher interest rates under almost every scenario and we need to prepare ourselves for that.

The one scenario where rates can stay low is if the Fed steps in with more open market activity.  Remember the Fed can still buy and sell US Government debt.  They simply can't sell new issued debt as that comes from the Treasury at the authority of Congress (the debt ceiling thing).

We appreciate all the feedback we get every week and I look forward to response throughout the week.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

tphillips@phillipsandco.com

Primary Research done by:
Adam Gulledge, Associate – Phillips & Company

Much Ado About Nothing - A Shakespearian Comedy That Exists today

Weekly Market Commentary 7-18-11

Tim Phillips, CEO – Phillips & Company

We’re into the weeds on the debt ceiling debate there’s no doubt about it. Like the Shakespearian couples in his classic comedy, there is a lot of talk yet no real outcome. I continue to stand by my prediction that much of this is political silly pre-season posturing and a debt deal is going to be finalized. What I'm trying to determine is the impact on growth and where to invest.

Let's review some current numbers:

• We have a $14.6 trillion dollar annual economy (GDP)
• We have a Federal budget of $3.7 trillion (26% of GDP)
• We have Federal income of $2.2 trillion (tax revenue)
• We have to borrow $1.5 trillion to make up the gap (deficit)

For every $140 billion dollars in cuts to federal spending we theoretically cut 1% out of GDP. These are big percentage cuts especially when the economy is only growing by 1.9% so far this year.

The so-called "political leaders" are bouncing around $1 trillion to $4 trillion dollars in cuts over 10 years or $100 billion to $400 billion a year. Given the big cuts to GDP and growth, I would be willing to bet almost all of these cuts will occur in the theoretical outlying years (years 6-10) of the plan. No one is really willing to make significant cuts to the budget and GDP while the economy is bouncing along the bottom.

Frankly, even in the outlying years $400 billion in cuts on a $1.4 trillion dollar deficit is a nice start, but doesn't begin to solve our problems.

Short of fiscal policy solutions, the monetary solutions are fairly straight forward - keep the US Dollar cheap relative to other currencies and inflate your way out of debt.

So what happens to asset classes when inflation is low and rising over many years?

We know one of the Fed's mandates is to keep inflation low, so we can anticipate much higher interest rates.  Here's a look at what asset classes do in rising rate environments.

Let's brace ourselves for lots of hot air and much ado about nothing.

As always we appreciate all of your feedback. Please email your thoughts and comments to me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

@PHCOAdvisors

Primary Research done by:

Adam Gulledge, Associate – Phillips & Company

Special thanks as well to:

Scott Edwards, Vice President of Wealth Strategies – Phillips & Company

Setting Up for Something Big

Tim Phillips, CEO – Phillips and Company

Last Friday, The U.S. Bureau of Labor Statistics released the June Employment Report. The numbers were dismal, and well below consensus.

• Only 18,000 total nonfarm payroll jobs added (consensus was 80,000)
• Revised down April and May payrolls numbers
• The unemployment rate increased from 9.1% to 9.2% (consensus was 9.1%)
• The participation rate declined to 64.1%
• The average workweek declined to 34.3 hours (consensus was 34.4)

Despite the dismal report, The Dow Jones Industrial Average closed down a little over 60 points (.48%) on Friday and was still up 722 points (6.16%) for the last two weeks. The numbers may have been below the consensus but the market wasn’t surprised.

In fact, if you look at the unemployment forecasts from the beginning of the year you can see we are still within the forecasted range.

If the market begins to expect slower than normal growth and the economic data is going to be range bound, then the market should be surprised if we see normal or even higher than normal growth. So the question is where is there an opportunity to surprise the market with better growth numbers? We believe the answer is 2^nd quarter earnings season, which Alcoa Inc. (NYSE:AA) will kick off today after the close.

We had a lot of one-time events last quarter:

• Flooding throughout the Midwest of the United States
• A massive earthquake in Japan followed by tsunamis and a nuclear meltdown
• Politics playing brinkmanship with United States budget and debt ceiling
• Threats of default across Europe
• The end of Quantitative Easing 2

It’s no wonder why analysts have been lowering forecasts. According to Bespoke Investment Group, “This is now the tenth week in a row that this reading has declined, representing the longest streak since at least late 2007.”

Investor sentiment looks to still be low and there is plenty to be worried about, but right now we’re trying to focus on where the high probability surprises will be.

As always we appreciate all of your feedback. Please Email your thoughts and comments to me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

@PHCOAdvisors

Primary Research done by:
Adam Gulledge, Associate – Phillips & Company

Effective Cash Management

Weekly Market Commentary 7-5-11

Tim Phillips, CEO – Phillips and Company

The Fourth of July celebration came early for the stock market. The S&P 500 closed up 5.61% and the Dow Jones Industrial Average closed up 648 points last week. We did suspect a bit of window dressing by fund managers because June 30^th was the end of the quarter but I don’t think anyone expected a week like that.

Figure

1 Chart of last week’s S&P 500 performance

I often get asked:

Why do professional money managers not use cash more as a tactical asset class?

My answer:

Weeks like that. Before last week the S&P 500 total for the year was 1.80%. After last week, the S&P 500 total return for the year was 7.57%. If you missed last week, you missed out on over 75% of the S&P 500 total return for the year.  We believe that timing the market is an exercise in futility. Investors should be more concerned about time in the market rather than timing the market.

Below is a table showing what happens to your portfolio return if you missed the best days between 1-1-91 and 12-31-10 based on the S&P 500

Figure 2 Data taken from Standard & Poor's chart which graphed how a $10,000 investment would have been affected by missing the market's top-performing days over the 20-year period from January 1, 1991, to December 31, 2010

If you missed only the 40 best days over a 20 year period (approximately 7300 days) your annualized return goes from positive to negative. 40 out of 7300 is not a lot of room for error when trying to time the market. If you’re paying 1% in fees and inflation is at 2% your real return can go from positive to negative after missing just the best 20 days. Investors can’t afford to miss weeks like last week.

Now that doesn’t mean cash can’t be used prudently. Cash can be an important asset class when it comes to having a proper asset allocation. It can provide a short term income to meet upcoming liabilities and liquidity needs and be used as a simple hedge against deflation.

It’s important to use cash the right way in order to maximize your return through asset allocation (which determines over 91.50% of your portfolio’s return) and not a market timing tool which accounts for less than 2% of your portfolio’s return.

With all this being said, in my experience having cash on hand to be able to buy things at the right time has usually been a pretty good investment strategy too.

If you have any questions or would like to discuss ways to more effectively manage your cash more in-depth please contact myself or your Registered Investment Advisor here at Phillips & Company.

Tim Phillips, CEO – Phillips and Company

Email: tphillips@phillipsandco.com

Twitter: @PHCOAdvisors

Primary research done by Adam Gulledge, Associate – Phillips and Company