Ramblings of a Portfolio Manager

Will We Get a Budget Deal and What Will Be Left of the Economy When We Do?

We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.

While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.

What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.

So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.

Ramblings of a Portfolio Manager

Here We Go Again?

We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.

Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.

As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.

Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.

So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.