Market Commentary: Government Debt Issues – All Eyes on Europe

"Americans can always be counted on to do the right thing...after they have exhausted all other possibilities." -- Winston Churchill

"[European] leaders have acted only in the face of impending disaster, and then with half-measures. Markets operate on a faster timetable." -- The Economist, July 14, 2011

As leaders in the United States and Europe wrestle with their respective financial dilemmas, the focus in our media has been on the US debt ceiling negotiations. The issue with more immediate implications on our investments however, may very well be the vulnerable financial status of various European countries and their banks – rooted in the financial collapse of 2008 and insufficiently dealt with by European leaders to date.

Whereas Churchill's quote above gives modern American politicians too much credit, it is likely that a resolution will be found so that the US avoids default. On the other hand, European politicians have yet to enact a comprehensive, confidence-inspiring action to calm their financial markets like was seen in the US in 2008. If not properly dealt with once and for all, the problems with Greek, Irish and Portuguese finances threaten to inflict losses on European banks, contract the European economy and spill over to US investors.

Both of these high profile events occur amidst the backdrop of a US stock market with decent fundamentals: 2nd quarter corporate profits have been good, food and gas prices have come down, interest rates are very low and will continue to be for some time, China has so far been successful in cooling their economy while maintaining solid growth, and Fed Chairman Bernanke has hinted at the intention to step in with more support if the US economy slows.

Investing in this day and age involves paying attention to the fundamentals while keeping an eye on the news headlines; the actions of politicians in the US and Europe are the key headline events right now. So how do we think these events play out? And more importantly, how do we plan to invest?

The US – Where Are The Debt Ceiling Talks Headed?

At the time of this writing, the President and Congressional leaders have concluded numerous days of talks to settle the impasse over raising the debt ceiling. There has been no agreement to date and each party's leadership is currently assessing what terms their caucuses would agree to in the way of future debt ceiling authorizations, tax increases and spending cuts.

Media coverage has justifiably increased its attention to the issue and is causing most of us quite a bit of stress. A default by the US would indeed be catastrophic. Moreover, to witness our politicians not compromising to avert a default over an issue, the near-term debt ceiling, that shouldn't be intertwined with deficit policy in the first place is a disheartening sign of our future ability to make tough decisions. What is needed now is a credible, medium-term plan balancing spending cuts with tax increases while limiting immediate cuts to spending.

It is very likely however, that the debt ceiling issue gets resolved. When politicians are involved, anything is possible. But the likely outcome is that a limited agreement is passed with the support of Democrats and non-"Tea Party" Republicans. Republicans affiliated with Tea Party support will not vote for any plan with increased taxes, especially if there are votes elsewhere willing to avert catastrophe at the cost of giving in. The mainstream Republicans gave in initially with a fallback plan (the McConnell plan), but it appears to be the Democrats who are giving ground in the end by agreeing to something based on this plan. There will likely be no tax increases, limited spending cuts, and President Obama will have the virtual authority to raise the debt ceiling through to the next election – he may end up looking responsible, but Republicans will attempt to blame higher debt levels on him.

Politically, it remains to be seen how this will be judged, but it appears likely the debt ceiling issue will be resolved. There will likely be some short-term relief in the markets, but any limited deal will not be received enthusiastically. A plan that doesn't accomplish very much reinforces that our government can't solve the deficit problem, and any near-term spending cuts will be contractionary to the economy. Washington politicians will likely avert a default so that the markets can instead pay attention to the great corporate earnings being reported this month. But it's the politicians of Europe that we need to pay attention to.

Why Should We Care About Europe?

The countries of the European Union introduced a new currency, the "euro", in the late 1990's in order to harness the combined economic firepower of Europe to benefit all member countries – much like each state in the US benefits from the strength of the dollar through low interest rates and in trading with each other and with companies all over the world. Until the financial crash of 2008, this union had been successful in raising living standards across Europe.

Now, however, flaws in the European Union's design have left it vulnerable to poorly-managed countries like Greece, with massive problems in tax collection coupled with borrowing too much money upon joining the union. Greek banks holding their country's government bonds are therefore at risk if Greece can't pay. Various other countries, mostly in the south as well (Portugal, Ireland, Spain and now Italy), also have similar financial issues – Portugal and Ireland standing close behind Greece in urgency. Banks in each of these countries in turn hold their country's bonds and furthermore, they each hold each others' bonds in various amounts. Therefore if Greece defaults, financial losses could ripple through the European banking system harming the economies of Europe and impacting stock markets, including in the US.

Thus far, European leaders (mainly the decision makers of Germany and France) have acted slowly to fix the crisis. With even Italy recently a target of the bond market, European politicians hopefully will have finally woken up to the fact that big, corrective measures need to be taken such as: a limited default for Greece, possible similar actions in Ireland and Portugal, a bigger "rescue fund" financed by European taxpayers, and/or jointly-issued bonds so that Germany, for instance, would guarantee the debt of weaker countries and appease their investors.

The markets await results from a meeting of Eurozone politicians this Thursday, July the 21st. Germany and to a lesser extent, France are the key actors – if they agree to in effect "bail out" the weaker countries in Europe, then the current European Union will be saved and economic damage can be avoided. It seems likely they will do something that will please the markets in the short-run, but I'm skeptical that they will have solved the problem for good.

US Markets and Our Investment Strategies

A lot of good things are happening in our economy and the world to lift stocks over the rest of this year. We're in the midst of a great earnings reporting season with companies like IBM showing tremendous growth and profitability. The tsunami in Japan depressed 2nd quarter activity so there's the potential for pent-up business to occur in coming months. Interest rates are low, and food and gas prices have fallen.

Unfortunately, politicians in both the US and Europe have the power to derail this market potential. My recommendation is that this is not the time to take a lot of risk. I don't advocate going out and selling all your stocks, but I do think it's a good time to lower the allocation to stocks somewhat, focus on safety, diversification and income, and increase the allocation to bonds and alternatives. The fundamentals look strong, but staying fully invested risks getting hurt by politicians' mistakes. The US will probably do the right thing, but Europe is more unclear – once we get clarity, we can focus on stocks fully again.

Here are our current investment strategies at Castle Wealth for stocks, bonds and alternatives:

STOCKS

· US large companies that pay dividends and operate as multi-nationals

· European companies with large exports to the rest of the world

· Healthcare stocks and other defensive companies

· International themes (banks in Canada for instance, Australia as a proxy for China)

BONDS

· High-quality corporate bonds (may benefit from the debt ceiling debate)

· High-quality municipal bonds (lower quality munis may be hurt by any federal cuts as part of the debt ceiling negotiations)

· Inflation-linked bonds (not planned as yet but will buy them as eventual inflation nears)

ALTERNATIVES

· Gold exchange-traded funds (possible future increases to the price of gold with uncertainty in Europe)

· Mortgage REIT's (high-dividend payers that have a great advantage as long as the Fed keeps rates low)

· Exchange-traded funds that mimic investment strategies of some of the most successful college endowment funds