August 5, 2014

'Taper' Tantrum

Last week, investors took a long look at the crazy quilt of information and events around the world and decided they didn't like what they were seeing.

Geopolitical tensions puckered a lot of seams: Conflict in Ukraine was embroidered with additional sanctions against Russia, difficulty investigating the downed commercial airliner in Ukraine, and escalating anti-American rhetoric in Russia. Violence continued to roil through Middle East and North Africa. In Libya, hostilities escalated, causing many western countries to withdraw diplomats and leading Tunisia to close its border with the country.

Financial and economic issues overseas, including ongoing issues with one of Portugal's largest banks, and worries that European companies will be negatively affected by sanctions against Russia, marred investors' views, too. In addition, controversy swirled around Argentinian bonds. In the midst of a legal battle over bond repayment, the country missed a June interest payment. The 'credit event' triggers a payout of about $1 billion for investors who hold insured Argentine debt.

Positive news in the U.S. offered some padding. The U.S. economy continued to recover and gross domestic product increased by 4 percent (annualized) during the second quarter which was a remarkable improvement after first quarter's contraction. Reuters reported, "Consumer spending growth, which accounts for more than two-thirds of U.S. economic activity, accelerated at a 2.5 percent pace... Despite the pick-up in consumer spending, Americans saved more in the second quarter... which bodes well for future spending."

The Federal Reserve issued a midweek statement confirming economic recovery was continuing apace. It caused some investors to throw what one expert called a 'taper' tantrum. Barron's said, "As the Fed's easy money policies reverse, people are forced to focus more on what they're paying for investments. If last week is any indication, investors didn't like what they saw in their portfolios."

By Friday, U.S. markets had experienced their worst week in two years. As investors adjust to the idea of rising interest rates, markets may experience additional volatility.

Budget Deficits

Just as some science fiction novels describe parallel universes, the Congressional Budget Office (CBO) report entitled The 2014 Long-Term Budget Outlook described alternate realities for the United States, including futures that will be determined by the decisions of our policymakers today and in the future.

The CBO reported, "Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing its debt to soar." A deficit occurs when the government spends more than it takes in. One consequence of recent deficits is the federal debt (the amount of money the United States owes its creditors) is now equal to about 74 percent of the U.S. economy's gross domestic product (GDP). That's the highest percent ever except for a short period around World War II.

If nothing changes - meaning laws governing taxes and spending remain the same, and the economy recovers as anticipated - deficits are expected to remain relatively low from 2015 through 2018. However, after that, the CBO projects government spending on healthcare programs and interest payments will grow and the federal debt could be 106 percent of GDP by 203 9.

In an alternate universe, "certain policies that are now in place but are scheduled to change under current law would be continued, and some provisions of law that might be difficult to sustain for a long period would be modified. With those changes to current law, deficits, excluding interest payments, would be about $2 trillion higher over the next decade than in CBO's baseline." In that scenario, the debt of the United States balloons, swelling to about 180 percent of GDP by 2039.

A more attractive alternative requires deficit reduction measures. Depending on the amount of deficit reduction, the federal debt could diminish and be 42 to 75 percent of GDP by 2039. We can only hope the United States isn't the country to answer an economic question recently discussed by The Conference Board: How high can debt-to-GDP ratios rise before crippling a nation?

Weekly Focus - Think About It

"The most difficult thing is the decision to act, the rest is merely tenacity."

—Amelia Earhart, American aviation pioneer

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management