The Context for the Debt Debate



History of the U.S. Debt Limit1

 
The last time Congress raised the debt ceiling was in February of 2010. At the time, it was increased by almost $2 trillion.
The fight in Congress over the debt ceiling and fears of a government shutdown are all over the airwaves, so I thought I would touch on a few aspects of the debate, and frame the context for the battle currently being waged in Washington.

History of the Debt Ceiling

The debt ceiling first came into existence in September of 1917. At the time, Congress authorized the issuance of $7.5 billion of bonds and another $4 billion of certificates of indebtedness under the Second Liberty Bond Act.

If we take that $11.5 billion dollars, adjust it for inflation from 1917 through 2011, outstanding debt would have increased to just over $193 billion dollars. The current debt limit exceeds $14 trillion. Washington’s “love affair” with debt has not only grown, it has grown exponentially since 1982.

Looking at the statistics of how US government debt has grown historically, I think it is important to look at two key points:

1. The debt ceiling did not hit the “magic” $1 trillion mark until 1982… less than 30 years ago.

2. Increases in the debt ceiling are quite common. Over this 94 year period since 1917, the debt ceiling was revised 102 times!

Also of interest, Congress has NEVER refused a President’s request to increase the debt ceiling, which is part of the current problem.

A second way to look at the debt ceiling is to look at it in relation to the nation’s Gross Domestic Product (“GDP”); or the market value of all final goods and services produced within a country in a given period. Looking at all available data on this comparison dating back to 1929, we can see that the all-time high for the debt limit to GDP occurred right after WW II when it exceeded 120 % of GDP. If Congress votes to increase the debt ceiling again this year, the debt limit could once again reach 100 percent of GDP. While the U.S. may not be fighting a world war this time around, it is borrowing money like it is.

Options for policy makers to bring debt levels down and cure its addiction to debt-related expenditures are to cut spending, raise taxes, or both.

Why Does the Debt Ceiling Exist?

In a nutshell, the debt ceiling is Congress’s way of setting a limit on how much the U.S. Treasury can borrow. Our Constitution presents Congress with the task of managing both spending and borrowing. When Congress’s appetite for spending exceeds available funds, the government borrows money via U.S. Treasury securities.

While the debt ceiling was proposed with good intentions, it has done little to stop our nation’s exponential rise in debt. More recently, it has become a source of political grandstanding, as policy makers attempt to “stand tall” against a debt problem of their own making.

How Could the U.S. Lose its Aaa/AAA Credit Rating?

According to the credit analysts at Standard and Poor’s, the rating agency would downgrade the quality of U.S. debt for the following reasons:

1. If Congress and the administration fail to come up with a “credible solution” to the U.S. debt and show no signs of agreeing on one in the foreseeable future.

2. If the United States misses any scheduled debt service payments, in which case S&P would issue a “selective default,” meaning a default has occurred on some bonds but not others.

3. If S&P concludes that the debt debate calls into question policy makers willingness and ability to timely honor the U.S. scheduled debt obligations.

How Does the Stalemate Get Addressed?

I think investors and Americans in general, would very much like to see a bold resolution to the current debt debate. In the end, though, a mini deal that satisfies neither side will probably get through and the debt ceiling will be increased. For the optimists, a grand bargain on spending, taxes, and debt will have to wait until after the next election.

From an investment standpoint, for the markets to retain their composure, they do not so much need a solution to the “crisis” as they need more certainty about the direction policy makers will take over the next few years. Stay tuned as the debt debate rages on.


Source 1: U.S. Treasury


Source 2: U.S. Treasury, Bureau of Economic Analysis


Source 3: Jason Geopfert - Sundial Capital Research, Inc.

Slowdown, Meltdown, or Short-term Correction?

Even in times of minor correction, we as individual investors feel the jitters of volatility. I always compare the emotion tied to investment for the individual to the feeling of being on a rollercoaster—markets go up and we have that feeling of anticipation and exhilaration, and as they fall it quickly turns to terror. It can be very hard to divorce one’s self entirely from the emotional side of investing.

While the individual views investment markets like a rollercoaster, institutions look at it like a railroad—with opportunities on one side of the tracks and risks on the other—and they aim to ride right down the middle of the track leaning toward opportunity when they can, and away from risk as needed.

The disciplined approach of the institution can be a tough one for the individual to mimic because of the emotions that play into buying and selling. Typically the euphoric feelings at the height of the market make the individual clamor for more, while the lows trigger emotions towards the exit. This leads to the “buy high, sell low” trap of emotional investing. Institutions take the opposite view; tuning out the noise, and looking for opportunities at the low, and exit strategies at the high.

So, how do we attempt to read through the lines of this current pull-back on the markets?  Let’s look at the economic data in May that potentially foreshadowed a slowdown

“Only 54,000 payroll jobs were added, auto sales declined significantly, retail sales were sluggish even excluding autos, growth in manufacturing slowed sharply, house prices continued to decline to new post-bubble lows (as of March), and home sales slowed.” (according to Calculated Risks Finance & Economics blog). Some of these issues could be attributed to interruptions in supply-chain in Japan following the earthquake (influencing auto sales), & rise in oil prices tied to geopolitics in the Middle East (influencing the price at the pump).

Monetary supply worldwide is on a tightening trend; which isn’t necessarily a bad thing. Responding to high inflation, both the Chinese and Indian banks tightened policy, which may slow growth, but it does not look as though they have gone too far to cut off potential growth completely.

Two political showdowns could play significantly on the continued upward trend of investment markets:

The first being the European Union’s move on Greek debt. If some form of restructuring is not rolled out, Greece could default and exit the Euro—a move that would not be good for any country participating in the single currency.  Domestically, the argument over the debt ceiling continues to be dicey; with one side refusing to cut spending, while the other refuses to raise taxes. Without action, the US government could find itself in technical default—though I do not believe politicians would make that type of dogmatic mistake.

Despite these risks, it bears to keep in mind that we are coming out of a steep recession fueled by a credit crisis, and after almost 2 years of positive growth, a correction at some point is inevitable. The economic data in the next couple of months will be telling as to whether we have a sustained pullback or if some of the shorter-term issues have been resolved—namely the slowdown in manufacturing fueled by supply chain issues. Taking an institutional approach to investment decision-making is not easy, but the ability to stomach normal corrections can prove to be the difference in meeting financial goals.

From an Investor’s Prospective: Understanding the disconnect between Wall St. & Main St.

Many people continue to ask how the stock market can have recovered significantly from the maelstrom of 2008, while the economy and employment still have the feel of “recession” to them.
The short answer is that the stock market is primarily focused on corporate profits. Hence, the stock market has done quite well over the past two years, a period of time when corporate profits have “surged” but the U.S. economy as a whole has merely “firmed up.”

The somewhat longer answer is that there is a very large difference between what drives “Main Street,” (the U.S. economy) and what drives “Wall Street” (the stock market). The table below highlights some of those key differences:

Source: BofA Merrill Lynch U.S. Equity Strategy

While your investment accounts may be enjoying the recovery in corporate prof­its, at the same time you may personally be feeling the effects of recession recovery (sluggish employment, higher than normal inflation, etc.). Hopefully, the above chart will help shed some light on the gap between recession/recovery “feelings” and what Wall Street may be “seeing.”

Separation Boom

While divorce rates over the past 2 decades has decreased, for couples over age 50 (particularly baby-boomers) it has just about doubled according to the National Center for Family & Marriage Research at Bowling Green State University.


The implications for couples divorcing later in life are much deeper for several reasons. Couples typically have accumulated more wealth by age 50, 60 or even 70, and this presents a greater degree of complication in dividing that wealth. Details such as long work history, real estate ownership, retirement account disparity, and life insurance can create a complicated mine-field for equitable division of assets.

Valuing Retirement Accounts at Divorce

One common mistake that is made with retirement accounts is that they are typically over-valued because the taxation is not considered. When looking at an equitable split of assets, the retirement accounts should be factored into the couple’s balance sheet with an after-tax value—sometimes as low as 65% of the current market value of the account.

Protecting Cash-Flow

If a divorcing spouse is awarded an alimony payment to aid in monthly income, the spouse who is set to be receiving alimony should take out a life insurance policy on the paying ex. Trying to plan for payments from an ex-spouse gets more and more risky every year after age 50, as the chance of them becoming ill or passing away prematurely increases with each passing year.

Because couples who are married longer than 10 years are entitled to Social Security benefits from the ex-spouse, divorcing couples will want to pay attention to the Social Security entitlement of their ex-spouse. Someone who earns less than their ex-spouse would want to claim the higher-earning spouse’s Social Security retirement benefit because it will be a higher amount. This is only the case so long as the claiming ex remains unmarried. If a divorcing spouse has a claim to your benefits, you should factor that in to negotiations on the dissolution of the marriage.

Protecting Assets for Heirs

To ensure that assets pass to heirs as originally intended, it sometimes makes sense to set up asset protection trusts upon the division of community property. This type of planning could protect divorcing couple’s children from the complications of remarriage, or from community property claims of their own divorces.



Divorce is a major life transition event, and needs careful consideration. For divorcing boomers, it can have significant impact on retirement feasibility and wealth transfer. Be sure that you understand the future repercussions of any settlement that you are structuring.

Watching the “known unknowns”

Equity markets seem to be struggling with “known unknowns”—that is to say we know there are some things we do not know—ending a volatile stretch of almost daily ups and downs for the market, creating a “risk on-risk off” tennis match for investors.

Here are a few of the questions that the market seems to be grappling with:

Known: Chinese import growth is slowing versus export growth
Unknown: Is this slowdown a sign of greater issues in Chinese growth leading to softer demand for outside goods and commodities? Or, is it indicative of high inventory levels in the country and demand will return?

Known: Commodity prices are softening
Unknown: Is price softening a result of slowing demand in China and other emerging markets, or a slow leak in a commodity price bubble?

Known: U.S. Dollar is rebounding
Unknown: Is it better for U.S. manufacturers to enjoy the benefits of exporting goods with a weaker dollar or for U.S. consumers to experience greater purchasing power with a stronger dollar?

Known: Consumers are feeling the pinch of higher energy and food prices with the April Consumer Price Index (CPI) rising 3.2 percent, the most since October 2008.
Unknown: Does this increase translate into broad long-term inflation across sectors or will consumers adjust to the new environment with little relative pain?


Time will sort out these unknowns and determine market leadership going forward. These unknowns must be factored in to the risk analysis for investors.

6 Items Keeping Boomers up at Night

While you can make the argument that investment markets have returned to normalcy over the last 12 months, there are still major concerns for those who are currently going through or about to go through the transition to retirement. Here are six issues of primary concern for the pre and early retiree

Inflation

According to a labor Department report in December, the cost of living only rose 0.1 percent last year. Looking at the price of various commodities, paints a very different picture. The Federal Reserves current round of quantitative easing has sparked a debate amongst politicians about its longterm affects on inflation. Sustained annual inflation about 3% could have a significant affect on a retiree’s purchasing power.

Parent-Child Sandwich

A prolonged recession has put some established boomers in the position of needing to support aging parents and unemployed children. Reports show many twenty-somethings have moved back in with parents in an effort to curb cost of living. According to 2010 Census Bureau data, 5.5 million Americans aged 25 to 34 live with their parents, up 38 percent from 2000. Last Novembers unemployment rate for people aged 20 to 24 was 14.8 percent.

Statistics show the same at the other side of the generational divide. A 2009 survey by the National Alliance for Caregiving showed 21 percent of caregivers for older adults said the economy had forced them to live together in the previous 12 months. An earlier study by the group found, on average, that families caring for older adults spend 10 percent of their income to do so.

Gold Bubble Bursts

Are Boomers going from bubble to bubble to bubble? Boomer investors irrational exuberance began in the tech sector in the late 1990’s; moved to a more tangible asset class in real estate in the early 2000s; and has poured into commodities (a traditionally volatile asset class) in the last few years. The price of gold is up more than 170 percent since the beginning of 2006 and hit a record of $1,431.25 an ounce last Dec. 7. Billionaire George Soros has predicted that the gold rush can't last, calling the precious metal "the ultimate asset bubble" at the World Economic Forum last January.

Bond Bubble Bursts

Speaking of bubbles, the other asset class that has seen a flood since the financial crisis in 2008 is bonds. Traditionally seen as a more conservative instrument than equities, bonds may be at the center of a perfect storm considering that interest rates are at historic lows. The relationship between interest rates and bonds is such that as rates rise, bond principal values fall.

Not Saving Enough

A 2010 Employee Benefit Research Institute survey shows 13 percent of workers aged 55 or older are "very confident" that they have enough money to live a comfortable retirement--down from 27 percent in 2000. Only 53 percent of older workers have actually tried to calculate how much money they will need in retirement, the survey said. The options for slow-savers are few: They can save more, work longer, or cut back on their spending. The EBRI survey found that 42 percent of older workers don't plan to retire until age 66 or later, up from 20 percent in a 2000 survey. Sticking one’s head in the sand will surely compound the situation. Figure out your capital need and hash out a savings plan sooner rather than later.

Too Much Company Stock

Still a problem I see with prospective clients working for well-established large corporations is the over-weight in company stock in their retirement plans. According to the Profit Sharing/401k Council of America, 18.1 percent of retirement plan assets last year were invested in employer stock. No matter what you think you know about the company you work for, there is still a prudent amount of exposure to have of your employer’s stock.


While this all seems like doom and gloom for the transitioning retiree, these are risks that can all be reduced or eliminated. While the risks and planning principals change during this part of your financial life, you can put an infrastructure in place to get through it.

Thoughts on measuring risk in an investment portfolio

Often when I meet with prospective clients to review their retirement holdings, their portfolio’s risk is measured in a ratio of equities-to-fixed income investments. This has been the traditional way to measure the overall risk of a portfolio, with the weight moving from the equity side to the fixed side as a client ages.

While this may be a simplified way of expressing risk, it may also be just that—too simple. I would make this argument for 2 reasons:

• Some bonds may be more risky that some stocks. It stands to reason that a debt instrument from an emerging market company could conceivably have more risk than an established dividend paying equity investement in the US domestic market

• Risk Changes over time. Volatility in the Emerging Markets asset class certainly is different today than it was 10 years ago, just as the risk of Real Estate or commodities has been an evolving factor over the last couple of years

To account for the changing risk levels regular and consistent analysis should be conducted. This process results in portfolios designed to take advantage of more attractive opportunities for investment while maintaining risk levels established by the analysis. It also allows for a portfolio to adapt as risk changes—of particular value when volatility spikes in the market for the pre-retiree investor.

A portfolio’s stock-to-bond ratio is greatly affected by whether the risk in a portfolio comes from a small allocation to emerging markets, a sizable allocation to high-yield bonds, or a moderate overweight of the equity allocation. However, an adaptive risk analysis can measure these options and determine to what degree a client’s risk tolerance can handle each.