The uncertainties of the last two weeks within the US political environment have been unnerving to stay the least. President Obama, two weeks ago, informed the nation that the US Congress has come up with a viable debt reduction program that would allow the debt ceiling to be increased. Less than one week later the President retracted his statement, and suggested there is still more compromise needed before he would sign any legislation into law. Needless to say, the financial markets reacted negatively in the final week of July, and to make matters worse, poor economic data for the month of July created an even more dramatic sell-off last week. Just as investors were starting to digest the new debt ceiling agreement Standard & Poors, a credit rating agency, downgraded United States Treasuries from the highest rating of AAA to AA+ with a negative outlook over the weekend for the first time in history (stock markets will not react well to this new development). Initially, we believed the positive employment situation reported on Friday would stabilize the financial markets, but the rating downgrade issued by S&P and the emergency meeting by the European Monetary Union has added to the market’s anxiety.
The New Debt Ceiling Bill (or lack there of)
After reading the executive summary of the new debt ceiling bill that President Obama approved last Tuesday, there is hardly anything to cheer about. The bill simply raised the debt ceiling through 2012 (after the election!), and in essence created a mandatory sub-committee that will debate a final bill for a vote no later than Thanksgiving. If a final resolution is not agreed upon by that date there will be mandatory cuts in defense and entitlement programs.
So, after months of debating, both Democrats and Republicans could not agree upon a long-term debt or budget solution, but they did agree to raise the debt ceiling by a couple of trillion dollars to avoid a default on our past obligations. Simply put, this was a terrible solution and the financial markets echoed this sentiment by the dramatic selling off last week.
ISM and Consumer Confidence
The Institute of Supply Management published their monthly report of business activity for the month of July, which was the worst report since June of 2009. The ISM manufacturing index came in at 50.9 (any reading below 50 is considered a contraction). The most worrisome component of this report was backlog orders which fell 4 points from June to 45, indicating that future manufacturing activity will get worse. In addition, future orders contracted to 49.3; its worst reading since December of 2009, and is the first reading below 50 since the recovery began three years ago Most economists and investors were completely surprised, forecasting the data would be unchanged or slightly higher after June’s positive reading. Overall, this report indicates the manufacturing sector is weak and suggests the future is going to get worse.
Consumer Confidence continues to be at depressed levels remaining well below 80; any reading above 80 indicates economic expansion. Currently, the Conference Board’s survey of consumer confidence for July was 59.5, slightly above the June reading of 58.5, and its worth noting that this number was published July 26th before the US Congress came to a stalemate over the final debt ceiling bill. The most telling component of this report was that jobs were hard to get, increased from 43.2 to 44.1, and consumers described business conditions as getting worse not getting better. I must point out that this indicator has not been above 80 since the economic recovery began back in 2009.
Standard and Poors Downgrade of US Treasuries
Probably the biggest surprise occurred this weekend when Standard and Poors downgraded US Treasuries’ credit status to AA+ with a negative outlook. Most strategists and economists believed this might happen in the future, but for S&P to move so swiftly was unprecedented. The other two rating agencies, Moody’s and Fitch, both affirmed their AAA rating on US Treasuries’. More over S&P cited that the government’s inability to handle their fiscal situation in a timely and uniform matter gave credence for the rating agency to act swiftly. The company also cited that the US Government does not have a responsible approach to handling the country’s debt obligations and its grasp on its current budgetary constraints. This undoubtedly will have major stock market and fixed income ramifications, both short and long term.
Employment Situation
The July jobs report that was issued on Friday came in much better than expected. Consensus estimated that 75,000 new jobs would be created and 117,000 new jobs were actually created. The private sector created over 150,000 jobs, and public sector contracted by 37,000. The unemployment rate ticked lower to 9.1%. Given the current ISM report most economists believed this report was going to be very disappointing. Unfortunately, this is a lagging indicator and gives investors no real definitive direction of future hiring in the months to come.
Our Strategy
After being positive on the equity market over the past few months, the recent developments over the last two weeks have changed our overall outlook and strategy. After being completely disappointed with our government’s ability to handle the debt situation in an effective manner, poor forward looking economic data, and S&P’s lowering the rating of US Treasuries makes it hard to be positive in the near term on the global financial markets. Even though corporate earnings have been excellent, most of their profits have been generated from abroad, and with the increased uncertainty facing the global markets there are too many headwinds that may prevent any significant stock market rallies.
The silver lining in this carnage is that the US Government is coming into an election year, and there is a considerable amount of motivation to get this economy back on track and instill confidence to the financial markets. Our hope is that policy changes come out of Washington that entice corporations to spend the massive amounts of cash they have sitting in reserves. The main difference between the current situation and the financial crisis of 2008, is corporations all over the world are in much stronger financial positions, and one can easily argue that they are the best positioned than any other time in history. Corporate earnings are what drive the financial markets, and we are not seeing any evidence at this time that the recent market sell-off is justified based on market valuations. To the contrary, there are certainly potential buying opportunities that are emerging.
In conclusion, the financial markets are going to continue to be extremely volatile in the near term, if the governments of the world make the correct policy decisions the financial markets will resume their upward trend. If policy makers continue their partisan ways, the entire global economy will suffer greatly. Over the next couple of weeks these themes will become more evident and we will make appropriate changes in our investment strategy. We will not succumb to the panic and fear that is dominating the financial markets at this time.
