Friday, July 22, 2011

Just the Facts - Closer Look at the US Debt Situation and Problems in Europe

Many of you have no doubt seen the doom and gloom that is being professed on the evening news, newspapers and on the internet almost every day. The old adage is “bad news sells”, and boy, is it selling these days. So far, in 2011 the world stock markets have been volatile to say the least. With the Japanese earthquake, the debt crisis in Europe and the debt ceiling in the US, one would think the markets have plummeted this year according to the media. In fact, the S&P 500 is slightly up year to date and the TSX is down approximately 1%.

The objective of my blog today is to provide you with some facts around the situation in the US and in Europe. First, in the US the second round of quantitative easing (QE2 which is an increase in the money supply so public debt can be serviced by the government) ended at the end of June. The current debt ceiling in the US is $14.3 trillion. The US has reached this and requires this be raised on order to service upcoming maturing government bonds. The deadline to raise this ceiling is August 2. Currently, the US is in a presidential election cycle so there is a tremendous amount of political posturing going on between the Democrats and Republicans. Both are trying to increase their favor with the voting public. The Democrats are suggesting a combination of modest tax increases and cuts to government spending while the Republicans do not want to consider any tax increases. While both parties negotiate a deal, I am of the opinion there is very little chance that a compromise deal will not get done. The alternative to the US not increasing the debt ceiling is not in anyone’s best interest. If the world’s largest economy defaults on its debt this will result in a downgrade to their debt rating (the rating institutions have threatened this to hopefully motivate the decision makers) which will increase their cost of borrowing and reduce the value of all the US debt currently being held around the world – the largest holder being the Chinese.

The Republicans passed a motion through Congress that will most likely be defeated in the Senate and President Obama has promised a veto which called for a cut and cap in government spending. It would allow the debt ceiling to be raised by $2.4 trillion as long as Congress approves a balanced budget amendment to the Constitution. As recently as yesterday, a bi-partisan Senate proposal has been circulated with a $3.7 trillion debt reduction plan. At the end of the day a deal will be struck.

The US is currently attempting to grow themselves out of their deficit by keeping their dollar artificially low (helps manufacturers export their products) and keeping interest rates low so consumers can continue to service their debt and get their balance sheets in order as well as encourage spending with homes, etc. Once a new president is elected and during the first year of office in 2013, this will be the opportune time to begin increasing taxes – perhaps a Value Added Tax, etc as currently the political will is not there to increase taxes.

If we focus on some of the economic statistics that have come out over the recent weeks, it is clear that recovery continues albeit at a slow pace. In the second quarter the US experienced a normal mid-cycle slowdown. The balance sheets of the banks are in a lot better position than they were 2-3 years ago (same with corporations and individuals). The expectation for hiring is good and credit is available. Loan charge offs and delinquency rates are down indicating improved consumer health. The unemployment rate in the US continues to go down albeit at a slow pace. If we look back 50 years on previous recessions, employment has taken longer to improve in each successive recession due to technology and continued increase productivity. If we expand our view globally, we saw 4.3% in annualized GDP growth in the second quarter of 2011 (World Economic Outlook, April 2010).

THE EUROPEAN SITUATION

Now turning our attention to Greece. Early in 2010, Greece’s inability to service their debt became evident to the rest of the world and the threat of the country defaulting on their debt was a real possibility. Thanks to the intervention of the International Monetary Fund and the European Central Bank a “line of credit” was established called the European Financial Stability Facility. As long as countries introduce measures to address the public debt problems than this facility is available to them. Greece, Ireland and Portugal have already accessed this facility. What it does is allow these countries refinance their debt in controlled, transparent way. To put things in context, the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) represent only 4% of world GDP (International Monetary Fund Estimate 2010 and CIA Fact Book 2010) and so long as Germany and France remain strong economic powers (as they are today), the threat of one or more of these countries defaulting and pulling the world into a global recession is remote. The other positive point is that the EU has taken ownership over the issue and convened various meetings and summits (one this week) to ensure there is a clear consensus among all policy makers. European leaders negotiated a Greek aid package yesterday during an emergency summit in Brussels. Banks will voluntarily agree to write down the value of their Greek securities by 21% as part of a bond buyback and exchange program. Europe’s 90 biggest banks hold about 98 billion Euros of Greek debt. This package will require the banks to contribute 54 billion Euros. (Bloomberg)

The most recent source of market volatility was the passing of austerity measures in Greece to ensure they would receive funding from the IMF and European Union. While these measures were met with public protests and political brinksmanship, they were passed in the end. While this is the first on many measures, I am sure there will be protests again at a later date. A summary of the Greek austerity measures include:

Tax Increases
· Solidarity Levy – applied to all citizens – amount dependent on income
· Lower Income Tax Free Threshold
· Sales Tax – VAT increased from 13% to 23%
· Wealth Taxes – yachts, pools, property

Spending Cuts
· Public Sector Wages decreased by 15%
· Public Sector Wage Bill – cut 150,000 public sector jobs
· Social Benefits Reforms – raise retirement age to 65
· Spending Cuts
· Social Contribution – cut down on evasion
· Public Investment – decrease spending on infrastructure

Privatization of Government Companies

They say that the biggest issues contributing to Greece’s debt problems is corruption resulting in poor tax enforcement (it was estimated that around 25% taxes are not being paid in Greece), corruption does not go along with transparency. What is important to keep in mind that with both the situation in Europe and the US, is that all the information is known and priced into the markets. It is the unknown or unforeseen events that trigger short term market volatility. It is important to ensure your portfolio continues to remain well diversified and actively managed. As well, maintaining an asset mix that matches your time horizon, risk tolerance and stage of life.

Cheers,
Chris