Provided by our affiliate, Kornitzer Capital Management

The chairman of the Federal Reserve Bank, Ben Bernanke, and his colleagues have used monetary policy tools to their fullest to help jump start and sustain the economic recovery. Through their control of the federal funds rate they have kept short-term interest rates near zero for some 2 1/2 years. Additionally, they have ballooned the Fed’s balance sheet to help keep long-term interest rates very low as well. Two years ago the Fed held some $1 trillion of securities assets. Today, they hold some $2.8 trillion of assets. In the early stages much of their purchases were mortgage backed securities to provide liquidity to a market that nearly shut down. More recently the Fed has aggressively purchased US Treasury securities. This recent program, dubbed quantitative easing #2 or QE2, has had the simple goal of keeping intermediate and long-term interest rates near record lows.  

QE2 officially ended on June 30th, 2011. This means the Fed will reinvest in Treasury securities as various holdings mature, but they will no longer expand their holdings. In other words, the Fed is no longer willing to print money to help fund future US government budget deficits. This is why Congress must act soon and convince other Treasury bond buyers that it is safe to continue and/or increase their purchases. What can they do to provide confidence to buyers? First, they must deal with the upcoming federal debt ceiling. The US Treasury currently estimates the government will run out of money in early August, if not sooner. Defaults could ensue shortly thereafter if the debt ceiling is not raised. 

Since 1917 there has been a legal limit on borrowing by the federal government. As we entered World War II, lawmakers gave the government blanket approval to spend as needed, as long as the total was less than the established limit. Since that time the debt limit has been raised almost 100 times with little fanfare. Why is it receiving so much publicly today? There are multiple reasons. First, the absolute level and growth trajectory of federal debt has become eye popping . At the current limit of $14.3 trillion the level of U.S. debt is now approaching 100% of nominal GDP ($14.9 trillion in 2010). This is the highest ratio since World War II.  

Next, the sovereign debt crisis in Europe is placing intense scrutiny on government finances. While the US is far from being another Greece (total government debt/GDP ratio of Greece is nearly 150%), the sheer size of the current US budget deficit (nearly 10% of GDP) is causing the ratio to deteriorate rapidly. When investors lose confidence in a country’s ability to manage its finances, a death spiral becomes a near certainty. Greek bonds yield in excess of 20%. The average yield on all US government debt outstanding is 2.5%. While there remains the possibility that Europe as a whole will guarantee Greek government debt (to forestall contagion to other countries and protect European banks), there simply is no one large enough to bail out the U.S.  

Other issues both impeding and helping passage of a debt ceiling/deficit reduction package include partisan politics and the ratings agencies. In previous newsletters we wrote that serious work by Congress on the budget deficit would probably not come (or be demanded) until 2012. However, the debt ceiling has accelerated this time table and is now being intertwined with a heated political debate over the budget deficit. Republican lawmakers are using the debt ceiling as a bargaining chip to secure deep cuts or caps on government spending. Obama wants budget talks to be separate from the debt ceiling or wants tax increases as part of the solution to the deficit. It is easy to pessimistic on any deal given the sharp idealogical differences between the two parties. However, the ratings agencies have already put U.S. Treasury debt on their watch lists for possible downgrade. They stand ready to downgrade our debt if the debt ceiling is not raised and default appears imminent. It is hard to believe the President or any member of Congress wants such a black mark in history on their resume.  

Thus, we are nearing a stage when it becomes crucial that Congress and the President meet in the middle and take real action to insure our country’s financial metrics improve over the long-term. The market understands that any deep short-term cuts will be too painful for a still weak economy. However, material, permanent caps on the future growth of the deficit over the intermediate and longer-term would be a huge positive. Hopefully, this is what will be delivered.  

Given all the above, the risks to the stock, bond and currency markets have risen and been pulled forward. However, we remain optimistic. In recent months, the stock market corrected some 7% over fears of near-term deceleration in economic growth. There is no denying the economy entered a several month soft patch. Part of the blame can be tied to the Japanese earthquake which disrupted manufacturing on a worldwide basis. Another part of the blame can be tied to rising commodity prices which put a crimp in real income growth. As the economy slowed, businesses held back hiring and payroll growth slowed. The good news is that these negatives are beginning to reverse themselves, giving hope to somewhat faster growth in the second half of 2011. Commodity prices have rolled over and the Japanese supply chain is recovering more quickly than anticipated.  

In the intermediate term, the outlook for the US economy continues to steadily improve. Even with the recent weakness, job growth has averaged 182K/month in 2011 versus 98k/month in 2010. Despite the pressure on real wages, the financial health of the consumer continues to mend. The US household financial obligations ratio (mortgage, rent, car, credit card and other loan payments to income) peaked at some 19% in 2007 and has dropped to 16.4% in the first quarter of 2011. While the consumer has been deleveraging, spending by businesses has helped pick up the slack. Exports are strong and spending on productivity remains a priority (to preserve profits margins with input prices rising). The main laggard in the recovery remains housing. With new housing starts still near 30 year lows, there is no over-supply of new homes. The culprit is existing homes. Due to the drawn out nature of the foreclosure process today, the flow of older homes onto the market has kept inventories high. Therefore, the recovery in housing starts is being delayed and only time will heal the market.

We continue to believe stocks are a far better long-term investment than bonds at current valuations. Many of our top US multinational companies pay dividend yields much higher than the current yield on the 10 year Treasury bond. Five years from now the yield (at cost) and market value of these stocks will likely be much higher (due to dividend increases) and the 10 year Treasury bond will likely have depreciated in value (due to inflation). This trade-off seems like a no-brainer to us. Our advice is to stay the course. Eventually, common sense will prevail.