An article at the website “Think Advisor” today got my attention with a catchy headline, “Your Clients Will Pay for World’s Debt, Advisor Warns“. The article paints the picture of a world with higher tax rates due to the inability of developed countries to reign in their debt. The last couple sentences summed up the entire article well:
But the bottom line is that today’s developed world, budgetary imbalances imply higher taxation. “The debt is going to have to be paid for one way or another,” Hatchuel says.
In speaking with clients over the past few years, I would say this is the prevailing wisdom. In fact, we were probably in the same camp up until a couple years ago, but the evidence is no longer suggesting that this is the case. Government deficits are not only shrinking, but shrinking fast. This is due to the slight bump in taxes, the sequester, but most especially growth in the economy. I am not sure that the theme of this article should still continue to be taken as fact. Let’s take a look at the government deficit.
You’ll see that since the recession hit, the deficit has been contracting. The Congressional Budget Office is now saying that the deficit has shrunk another 20% over the first two months of fiscal 2014. Are we still spending more than we bring in? Yes, but the gap is closing fast and the debt as a percentage of GDP (a figure used by most economists) is expected to stay fairly stagnant over the coming years, and that is without any additional tax increases. Growth cures a whole lot of our ailments. If the US is able to continue its modest recovery over the comings months and years, there is a good chance that higher taxes may not be necessary to close our budget gap.
If you were to ask most investors what is the least risky investment you can purchase you probably wouldn’t be surprised to hear treasury bonds and gold as their answer. Treasury bonds are literally considered risk free assets as they are backed by the full faith and credit of the United States. Gold has historically been known as a great “store of value”. The thought goes that countries can devalue their currencies but gold will always hold its value through periods of extreme inflation or deflation.
So let’s say going into 2013 you were worried about the upcoming year. You’d probably have quite a few reasons to feel that way. Although it was a long time ago, you probably remember the “fiscal cliff” fiasco, strained government negotiations, higher tax rates, sequester spending cuts, and the upcoming rollout of Obamacare. In anticipation of these events you might have decided that this was a time to get “safer” with your portfolio, allocating a healthy dose of gold and treasury bonds to your portfolio mix. Let’s take a look at how you would have fared.
Treasury Bonds (as measured by the TLT ETF) is down around 12% this year. Gold is down 25% for the year. The point of this post is not meant to say these investments should not be in your portfolio (well, maybe not gold), but that trying to outsmart the market by re-positioning portfolios based on what direction you think the market is going is a dangerous game. The other lesson we have learned is that even perceived safe investments can lose money.
I have been having more and more conversations with clients that all seem to go something like this, “How can the stock market keep climbing? The government has a record amount of debt, our politicians are completely inept and the economy just doesn’t seem to be getting that much better”. It is a tough concept to understand, but it is an important one. The economy or our political system is NOT the stock market. Yes, our economy could be struggling to grow fast enough. Yes, our government has too much debt. Yes, our politicians can’t agree on one thing. But, that does not mean that the stock market will be lousy.
As an investor in a company, what do you care about? You care about the company’s earnings. That is typically why you buy a company…to make money. With that being said, this chart gives you some insight into why the stock market is at an all-time high:
Corporate profits have exploded higher which over time is what drives stock prices. Now you could argue that all of the concerns I listed above will translate into shrinking corporate profits, but we haven’t seen it yet. If that is your contention, ask yourself when this is going to occur. We have been experiencing all of these issues for the past 3-5 years but it has not effected the market or profits in any sustainable way. As we’ve said in the past, we’d recommend ignoring the noise from Washington and focusing on the information that actually has been proven to have an impact on returns. We’ll touch on those factors in a future post.
Whatever your feeling about government spending, it would be hard to argue that the fiscal austerity we have seen over the past several years has not slowed growth pretty substantially. Moody’s put out a chart on this phenomenon:
The chart shows how much a drag government spending cuts have been on our overall GDP growth. Over the past 3 years this austerity has shaved off between 1 to 2 percent per year. When you are only growing at 2 percent this is pretty significant. While this austerity and its impact on our economy is easy to understand, what is harder to determine is whether this has been good or bad for our overall economy. On the one hand, because of these spending cuts we have seen a massive shrinking of the US deficit over the past few years which is putting us on a much more solid footing as a nation. On the other hand, because of this belt tightening, growth has been at stall speed for a fairly long period of time. This has prevented the economy to meet its full potential causing a much higher unemployment situation than desired. Both sides have a valid argument for their policies and the best part about this situation is that each side is both a little happy and a little frustrated. That is usually a pretty good sign.
From an insider’s perspective the last few weeks seemed to be the perfect time to be a gold investor. We had the government shutdown causing a slowdown in economic activity and even more importantly, it looked like we were heading for a potential breach of the US borrowing capacity which had the potential to cause a default. In times of great uncertainty (which is probably an understatement from the past few weeks), gold is often thought to be the investment of choice. This was such common wisdom that Goldman Sachs came out with a research report that gold was a “slam dunk sell” once the crisis was over since that was when the uncertainty would be removed.
There is an old saying that markets tend to do what makes the most people uncomfortable. Gold is no exception. Here is the chart:
So, gold fell through the lead up to the shutdown and until it looked like a deal was going to be reached. So during the period of maximum uncertainty, gold fell. Once resolution to the crisis was in sight, gold has been climbing. This tells us two things that we already knew. First, gold is not the great diversifier that everyone thinks it is. We saw this over the past few weeks and we saw it during 2008 as well. Second, no one can predict how the market will respond to events. The more certain you are, the higher the probability that you will be wrong.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.