Carlin Financial

In simple terms, the debt ceiling is the total amount of debt that Con­gress has authorized the Treasury to incur backed by the full faith and credit of the republic. And that au­thorization currently is limited to roughly $14.3 trillion. That may seem like plenty of headroom, but we are bumping up against the ceil­ing, at least the way Congress is le­gally bound to define it.

The biggest chunk of the debt is in the form of outstanding Treasury securities. That’s the “debt held by the public” which at the end of fiscal 2010 (last September 30th) stood at just over $9 trillion. Eight months into the current fiscal year the Trea­sury’s Debt Position and Activity Report shows $9.72 trillion in debt held by the public. By the way, that “public” is vast; about half of that outstanding debt is held by non-U.S. investors: foreign nations, institu­tions, and individuals.

So, if total debt held by the pub­lic is just approaching $10 trillion, why are we bumping up against a $14.3 trillion ceiling? That takes us into the world of the Social Security and Medicare Trust Funds. Those “funds” are a historical accounting of the excess of payroll tax collec­tions over Social Security and Medi­care expenditures. Over the past 25 years that excess has been consider­able, and by law it must be credited to the respective Trust Funds.

Of course the actual cash has been spent along the way, leaving the Trust Funds with special, non-traded Treasury securities on which the Funds are credited interest as time marches along. These accumu­lated “balances” provide a useful re­cord as well as the legal framework within which Social Security and Medicare benefits will continue to flow at whatever point payroll taxes fall short of those outlays.

Those Trust Funds represent the largest portion of what Treasury’s Debt Position and Activity Report lists as Intra-governmental Hold­ings, totaling $4.62 trillion as of May 31st. It may seem counterin­tuitive, but the law requires those “balances” to be counted as part of the total debt capped by the ceiling.

Whether this truly constitutes a debt or just a formal recognition of a compact across generations makes for an interesting discussion. But as the accompanying table shows, the plain old debt held by the public is growing plenty fast enough to lend a sense of urgency to the ceiling de­bate and highlight our political and philosophical divisions.

 Depending on the day, the Eu­ropean Monetary Union is either heading for a cataclysmic break up or crafting a grand solution to its contagious sovereign debt crisis. This scrum started nearly two years ago when Greece disclosed a budget situation much more dire than previ­ously admitted. At the time we noted that this was but “the first major call­ing of a question at the heart of the EMU project: How does a common currency handle very divergent fiscal stresses among member countries?”

The rolling crisis has continued to illuminate certain genetic flaws in the common currency scheme. For starters, there is no real lender of last resort positioned to stop a sustained run on the financial and payments system itself. European banks are primarily governed by and closely associated with their respective home governments. Yet their key role in commercial lending and their signifi­cant holdings in cross-country, euro-denominated debt create systemic risk across the continent.

Although today’s biggest con­cerns are focused on the likes of Greece, Portugal, Spain, and Italy, it was France and Germany who first violated the fiscal guidelines in the Stability and Growth Pact under which the currency union was launched in the 1990s. The EU Com­mission has not been inclined, then or now, to impose censure and/or sanctions on members of the club.

The EMU has sometimes been characterized as a “United States of Europe,” with some of its more fis­cally impaired countries compared to states with high profile budget and debt challenges (e.g., Califor­nia, New Jersey, Illinois, et al). But there are key differences. In the U.S. the federal government can tax the residents of all states and borrow on their full faith and credit. Many states are precluded from sustained deficit spending by their respective constitutions. Perhaps most importantly, in a fully integrated national economy with a common language, American taxpayers and businesses can much more easily abandon a state whose fiscal profligacy leads to onerous levels of taxation or an unacceptable decline in public services.

At this writing the euro zone’s largest players are struggling to pull together a consensus plan that can overcome its genetic defects while respecting the sovereignty of member countries. All eyes are on Germany, justifiably proud of its global com­petitiveness due in part to its own painful labor and economic reforms of a decade ago. But as it touts the virtues of reform and fiscal rectitude, Germany knows that its economy draws heavily on the viability of its euro zone neighbors. Pressing for a level of austerity that ends up tanking the region’s growth prospects would be a Pyrrhic victory indeed. That’s the circle they hope to square.

If you sense that the bond market has been a kinder and gentler place than the stock market lately, your sense is pretty good. And it’s not just lately. As of the end of the third quarter, the 30-year total return on long-term Treasury securities edged ahead of returns for the Standard & Poor’s 500, a market-weighted index of 500 large, publicly traded U.S. companies. The last 30-year stretch when that occurred was back before the Civil War.

 It’s not that stocks have done badly over those three decades; the S&P 500 annualized 10.8%, not far below its longer term average. But the period featured an epic bull market for bonds with long Treasuries posting annualized total return of 11.5% according to Bank of America Merrill Lynch’s U.S. Master Treasury Index.

Bonds certainly have had a better 2011 than stocks as shown by the accompanying table of one-year trailing returns for major mutual fund categories. The five- and ten-year trailing numbers illustrate the edge that fixed income investments have had over the past decade.

 A long-awaited reversal of the historic decline in interest rates has yet to materialize here. But in Europe the bond market “vigilantes” are insisting on higher yields to finance over-indebted governments. Markets were unnerved recently when even Germany, Europe’s largest and strongest player, had trouble floating a bond offering as it began to look more likely that the euro zone crisis would ultimately tap German resources to a significant extent.

Meanwhile the cross currents potentially affecting U.S. interest rates are tricky. Recent economic numbers look encouraging which normally would be expected to nudge rates higher. And it’s not as if we don’t have our own debt concerns. But the euro zone crisis and investors’ general risk aversion has continued to drive money into the sovereign debt of the keeper of the world’s reserve currency. Plus there’s the Federal Reserve’s express commitment to keeping rates low. Maybe Uncle Sam can evidence just enough fiscal and economic progress to keep investors from souring on his IOUs as well.

      The past few years, not to mention the decade, have put investors through a wringer.  No need to rehash all the highs and lows.  In fact, there may be too much attention paid to the highs and lows at the expense of long-term objectives and strategy. 

      Stocks suffered mightily in 2008, so in 2009 investors poured unprecedented sums into bond funds.  Then in response to the big comeback rally, stock fund purchases surged in late 2009 and early 2010.  Investors also have chased gold and oil across their respective peaks and valleys.            

      For those with a longer time horizon, signals from the past decade may be deceiving.  It’s not just that the Standard & Poor’s 500 Index had one of its worst decades ever.  The outperformance by long-term Treasury bonds over stocks was also a record – an 8% annualized spread. 

      Such periods are rare.  A study of 889 monthly rolling 10-year periods from 1935 through 2009 showed Treasury bonds beating the S&P 500 only 14% of the time.  The average for all periods was a 5.3% annualized advantage to the stock side.

      Historical reassurances are fine, but those 300-point down days for the Dow are jarring in real time.  We might take a little more current comfort from stock dividends.  Dividend payouts did fall in 2009, but they’ve been recovering lately.  And analysts have noted the relative strength of corporate balance sheets through the recession.  By the end of 2009 the S&P 500’s dividend yield was approaching the 10-year Treasury bond yield, and 72 stocks in the S&P were sporting dividend yields above that benchmark.

      Last year’s rally was led by the lower dividend payers, which is common in the rebound from a steep market decline.  But over the trailing ten years, stocks that paid higher dividends outperformed.  And advancing the argument for global diversification, many non-U.S. companies pay higher dividends.

      With interest rates at historic lows and most of the world’s central banks still quite accommodative, gold has been hitting new highs.  Gold’s longer record is as an inflation tracker, and the ride can be bumpy.

      To everything there’s a season; it’s just hard to know which comes next.  But it’s always a good time to check and see if we’ve become overweighted to short-term concerns at the expense of broad diversification and long-term objectives.  ■

Chris Carlin, CFP® appeared on The Morning Blend on Tucson’s KGUN9 where she discussed why it’s important to have a financial plan. See the video at:

http://www.tucsonmorningblend.com/videos/93776264.html

February 15, 2010 – U.S. Brands Still Pack Global Punch

Global markets have been dissing the dollar.  But a wide-angle snapshot of any large currency trading floor is apt to show a can of Coca-Cola on at least a few desks.  In a recent Business Week article on the “100 Best Global Brands”, Coke topped the list with the world sipping more than a billion services daily.

U.S.-based companies claimed eight of the top ten brands and 53 of the top 100.  Other high-value brands included IBM, Microsoft, GE, McDonald’s, Google, Intel, and Disney.  Business Week’s ranking methodology stipulated that a brand “must derive at least a third of its earnings outside its home country, be recognizable beyond its base of customers, and have publicly available marketing and financial data.”

The Quarterly touched on this a decade ago in an article titled, “Are You a Global Investor? It’s Hard Not to Be,” nothing some of these same companies’ substantial participation in growth opportunities across a broadening swath of the globe.

One reads a lot about a disconnect between Wall Street and Main Street.  Part of that starts right here.  Wall Street caters to many of these same major companies and an increasingly global clientele.  It looks more and more like the recovery under way in many parts of the world will  not be led by Main Street U.S.A.  That may take some getting used to, but considering their high-profile global brands, leading U.S. companies may be rather underappreciated.  And the main disconnect may be between those who have capital to invest, whatever street they live on, and those who don’t.

Nothing contained herein shall constitute an offer to sell or solicitation of an offer to buy any security.  Securities are offered through KMS Financial Services, Inc.  Material in this publication is original or from published sources and is believed to be accurate.  Readers are cautioned to consult their own tax and investment professionals with regard to their specific situations.

February 10, 2010 – The New Carry Trade: Gaming the Dollar

Two-and-a-half years ago, the Quarterly commented on the “yen carry trade” then in vogue with global traders and speculators.  As Japan’s post-bubble malaise extended well into its second decade, the country’s persistently minuscule interest rates had made the yen carry trade a pretty reliable way to lever up incremental returns.

Today the talk is about the dollar carry trade.  A shaky U.S. recovery and historically low short-term treasury yields are enticing traders to borrow in dollars to purchase a range of other assets.  Global equities, high-yield bonds, gold, and other commodities have benefited (see the trailing one year numbers in the accompanying table).

This weighs on a U.S. dollar already under price pressure from the flood of liquidity released by the Federal Reserve’s machinations and concerns over unprecedented federal deficits.  With the Fed signaling that it will keep rates very low for an extended period, the dollar carry trade has looked like a one-way bet.

Such bets can sow the seeds of their own demise.  Many of the assets reportedly benefiting from the dollar carry trade can be dumped rather quickly.  And as we noted a couple years ago, “currencies can shift faster than the time it takes to profit on an interest rate arbitrage.”

Signs of healing for the U.S. economy could hit the dollar carry trade hard.  Markets got a taste of the hair-triggered possibilities the other day when November employment numbers came in stronger than expected.  The greenback rallied and gold gave up 4% on the day – not a game for the faint of heart.

Nothing contained herein shall constitute an offer to sell or solicitation of an offer to buy any security.  Securities are offered through KMS Financial Services, Inc. Material in this publication is original or from published sources and is believed to be accurate.  Readers are cautioned to consult their own tax and investment professionals with regard to their specific situations.