Investment Policy Committee Notes
Summary Points:
- Debt ceiling saga continues to keep markets in flux
- Debt Rating agencies forewarn of credit downgrades for the world’s few AAA rated countries
- The European Union scrambles to reschedule Greek debt
- The Municipal bond market somewhat stagnant as investors await Congress’ decision on the debt ceiling
- 2nd Quarter company earnings continue to outperform
Discussion
Needless to say, there is a barrage of perceived and real worries in the world today. Most pressing in our view, however, is the topic of the United States debt ceiling, and the anticipated outcome of Congress’ decision to either raise the limit or let the U.S. default. The Donaldson Capital Management Investment Policy Committee (“IPC”) discussed at great length what truly constitutes a default. We have read many publications, and watched several news conferences in order to learn of the possible outcomes.
Timothy Geithner, the U.S. Secretary of the Treasury, seemed to dance around an interview question on the plausibility of the U.S. defaulting on its obligations. Although he did not confirm that the U.S. would default, he did say that by definition the U.S. could be in a ‘technical default’. Essentially we understood this to mean that without the debt ceiling being raised, with the current level of Government outlays exceeding tax revenues, certain obligations would not be paid.
This is where it gets a bit fuzzy. There will be a natural order to things, or rather, a priority of who will get paid first in the hierarchy, but how that order is defined is the real question. While difficult to determine who would get paid and who wouldn’t, the Government realizes that its creditors are made up of countries and large institutions with a strong investing prowess. Therefore it is very important the U.S. make good on its debt obligations to these creditors because we will have to go back to them for future borrowing needs.
However, should the U.S. fix its deficit issues off the backs of those dependent upon their monthly paychecks such as retirees or the disabled by taking away or reducing these benefits? Either way you look at this issue, it’s very difficult to determine the best way to solve the problem at hand.
The markets have responded to the expanding uncertainties with mixed emotions. They have become more volatile in the past few weeks but have traded in a reasonably narrow range. What seems to be the issue with the uncertainty is uncertainty itself.
Another correlating variable to the volatility of the markets is the debt rating agencies’ warnings of decreasing credit ratings for some of the strongest countries in the world. Standard & Poor’s rating agency, along with Moody’s and Fitch’s have all stated they will remove the U.S's AAA rating should either no deal, or a perceived insignificant deal, be passed. This trend has extended, however, to other countries such as Germany. This is rather surprising considering the positive attention the Germans have received for their strong fiscal budget and spending discipline.
This may be an unprecedented time in history to have the world’s ‘riskless’ investment (i.e. U.S. Treasury bonds) take on the risk by being downgraded. What, then, should the world use as a benchmark for risk premiums, capital cost configurations, and the like? It is the belief of the IPC that no matter the outcome, the U.S. policymakers will do what they can to prevent default and perhaps safeguard the status quo.
Not only so, but as it pertains to investors, differing investment options are graded on a curve. When surveying the world and all the differing investment securities available (from stocks, to bonds, to cash, to foreign currencies or securities, etc) investors perform a mental accounting to rank various investment options against each another. While there is the real possibility the U.S. debt rating could be downgraded, generally speaking the U.S. is still one of the safest places in the world to invest one’s money.
A comparison to the bailout plan offered by the European Union to support Greece shows the situation in the U.S. could be much worse. Private holders of Greek debt are taking a 21% haircut on their investments, which is causing grumbling among investors. As we have seen, a rippling effect can occur across the European Union should one country default on its obligations. We are optimistic, however, to see that a new Greek debt restructuring plan should whittle down the country's debt-to-GDP ratio closer to 100% (a more manageable level).
The IPC then turned its attention to the municipal bond market and noted that the issuance of new bonds has slowed dramatically. It would take several more paragraphs to explain why, but Congress’s decision to limit new Treasury bond issuance as we near the federal debt ceiling has had the effect of reducing the number of new municipal bonds coming to market. Therefore, the municipal bond market has now been, at least temporarily, impacted, by the debt-limit standoff.
That is not good news, but there is some good news about credit quality in the municipal bond market. A recent analysis of our bond holdings showed significantly more upgrades than downgrades. In fact, the municipal bond market as a whole has fared very well this year, especially in retrospect to analyst Meredith Whitney's dire prediction. If you remember, she proclaimed there would be hundreds of billions of dollars worth of defaults in 2011. So far in 2011, only $750 million have defaulted; a far cry from her forecast. This compares to the amount defaulted in 2010 and 2009 of $2.5 billion and $4 billion, respectively.
Lastly, the IPC discussed corporate earnings for the 2nd Quarter. So far in this earnings reporting season, a little over 200 companies within the S&P 500 have reported. Earnings have continued to outperform in both year-over-year growth,18%, as well as earnings surprises,7.5%. (defined as the difference between actual earnings and analysts’ estimated earnings.) These big earnings gains have also resulted in sizable dividend hikes. In our two main dividend investment styles, dividend increases over the last year have averaged nearly 14%, the highest growth rate in many years.
In the spite of all the news that is causing volatility in the stock market, U.S. companies are still expanding and growing at an impressive rate.
Many questions remain regarding the final outcome of the debt-limit stalemate in Congress. Because this stalemate involves the heretofore safest investment on earth, U.S. debt securities, the options for a perfectly safe hiding place are very few. Furthermore, we remain convinced that this stalemate will be broken and when it is the few investments that are doing well right now like gold and Swiss,Canadian, and Australian currencies will fall in price. In essence to invest in these securities at this time is to bet that the U.S. will not only default but remain in a defaulted condition for an undetermined time.
As we have said on many occasions, it is becoming clear that high-quality, multinational corporations may now be the safest investments in the world. They have piles of cash, significant free cash flows, modest debt loads, compete in every corner of the world and charge a price for their services dictated by the market and not decree, pay taxes in every country in which they operate, and return a significant portion of their annual earnings to their shareholders in the form of dividends. Go back through this list of attributes and you will find few similarities with most sovereign debt in the world.
We'll report again next week on how the fiasco in Washington DC is playing out.
