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Second Quarter Investment Outlook: Governments Deep in Debt, the American Consumer…. Not so Much

By: Denny Fulmer, CFA
Wednesday, July 5, 2017

As we go to press, it looks as if the state of Illinois will avoid their bonds being downgraded to non-investment grade or “junk” bonds. Chicago bonds are already in the junk category and Chicago Public School debt is ranked even lower.  Underfunded pension plans are Illinois’s main culprit, as they make up over three times the amount of Illinois’s traditional debt.  The new budget features a 32% tax increase and does little to address the pension costs.  Unfortunately, this same unwillingness to face up to the horrific mathematics of entitlement programs extends to our Federal Government. 
Now for the good news- the American consumer is in pretty good shape.  A recent Wall Street Journal article states that “household’s debt-to-income and debt-to-asset ratios are at postcrisis lows.”  Mortgage debt is way down and credit-card debt remains low. The only bad news is that student loans are up sharply, but not nearly enough to offset the good news with mortgage debt.  Ironically, consumer spending has not been very strong this year even though consumer sentiment is strong.  Perhaps having their debt under control is what makes consumers feel good about the future!  This bodes well for the longevity of our economic recovery, as our consumer has the financial strength to sustain the albeit modest growth in his spending.
So what does this mean for the stock and bond markets?  The massive increase in Government debts and unfunded obligations offsets the progress made by American households, so our society is in a debt hole and we keep digging it deeper.  As we mentioned in the Outlook a year ago, Economists Reinhart and Rogoff issued a paper in 2010 which predicted that a higher debt burden results in slower economic growth.  The slower growth also impacts the investment markets, retarding profit growth and keeping interest rates abnormally low.  Therefore, we think interest rates are likely to remain very low, and we actually hope they will slowly rise to more normal levels.  The low rates keep the backdrop the same for the stock market, as the higher valuation level is justified from the lack of any serious competition from bonds.
What can go wrong?  Investors worldwide still seem very eager to buy government debt from any of the major developed economies.  Why? Because they still have confidence in the security and safety of these bonds.  If this confidence is lost, then the markets would go down significantly.  Fortunately, the United States is in much better shape than Japan, France or Germany.  Weaker countries such as Greece (remember them?), Italy and Spain still have the confidence of the bond markets as long as the European Union holds together, because that means Germany will support their debts.  No one knows where the tipping point will be, but Illinois is getting closer to it and Puerto Rico is already in default on their debt.    Perhaps these fiscal issues are permeating down to consumer decision making and restraining their spending.
Our conclusion – This doesn’t change the basics on stock picking; we still think you want to own stocks that sell at reasonable prices.  The value of our currency has steadily declined since we left the classical gold standard after 1932, and we expect that to continue.  However, keeping some reserves on the sidelines makes some sense as the risks are rising.  The American voter is at fault for wanting benefits but expecting someone else to pay for them.  The political leaders are at fault for not being willing to face the unsustainability of the promises they have made and the media is unwilling to hold the big spenders accountable.
Sources: “They Myth of the Indebted American”, by Justin Lahart, Wall Street Journal, June 8, 2017.

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