Weekly Market Commentary 6-25-12

This week, the Federal Reserve made a widely expected move to extend Operation Twist (the buying of long-term government bonds and selling of short term government bonds). This program is intended to lower long term interest rates and help make financial conditions more accommodative. Along with extending Operation Twist, the Federal Reserve also lowered their expectations for GDP growth to 1.9% - 2.4%, down about half a percent from April according to the Economic Projections of the Federal Reserve Board Members, release on June 20th. Clearly, the Fed still sees weakness in our economy and they don’t want to be the cause of more pain and suffering by tightening the money supply too early.

The Fed sees something our policy makers (aka politicians) don't see or refuse to acknowledge yet. We are now, for the first time in a long time, a country that must pick winners and losers. Allow me to explain.

Generally countries take on debt to finance their needs when the economy slows down, and they depend upon a growing economy to "bail" themselves out when the debt comes due down the road. It’s a win-win because we can increase spending and lower taxes in recessions, and then pay back the debt during economic expansions and smooth out the overall economic cycles. This meant people got their benefits, taxpayers paid lower taxes and the economy recovered quicker.

This is how President Reagan was able to triple the nominal debt level from 900 billion to 2.8 trillion, but only increase the debt to GDP ratio from 26% to 41%. The growth in GDP and tax receipts were able to offset some of the increase in spending and taxes cut elsewhere.

The key to this type of fiscal approach is that the long run GDP growth must exceed the long run deficit spending. Unfortunately, as you can see from the chart below our deficit spending has far outstripped our GDP growth over the last 10 years.

Because of this, our total debt has now eclipsed 100% of our annual GDP according to the IMF and the interest on our debt now represents 6% of our total government spending for 2011 according to the CBO.

We could be at the end of this, “win-win era.”

The Fed gets that our economy has been used to having it all, but the political class has not. In order to keep the “win-win” dream alive we will likely need to borrow massive amounts because our financial picture is not the same as it was in the 80’s.

If we are at the end of the “win-win” era that means we must pick winners and losers. With persistently low GDP growth over the last 10 years, we are now faced with choices:

• Pensions for public sector employees or tax cuts?
• Food stamps for the poor or defense spending?
• Unemployment benefits for the jobless or Pell Grants for those that want to go to college?

Unfortunately, we are likely at a paradigm shift and about to realize we are now a “win-lose” society that will need to make choices. Perhaps, the Fed realizes we are simply not ready to make those choices and their only response is to keep rates low to give the political class more time to figure out who wins and loses.

As for portfolio considerations, whether you have an aggressive allocation with an 80-20 blend of equity and fixed income or a very conservative mix, we are continuing to take into account the slow GDP growth environment when we are designing our portfolios while we wait for the political class to wake up.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company