It May Be Time to Consider a Broader Strategy
by James Battmer
Prudent investors should consider options abroad amid U.S. fiscal mess.
Over $6 billion in total dollars and an even larger amount of ill-will spent in the elections of 2012. The outcome? A pitched battle with many casualties but little actual movement—more akin to the trench warfare of World War I. Unfortunately, the real political battle that will have a far greater effect on the economic prosperity of our country is just getting started. So how should investment portfolios be positioned now to not only survive but benefit from this uncertainty?
Much has been written of the looming fiscal cliff, with simultaneous expiration of over $4 trillion in tax breaks, the implementation of health-care reform, and the sequestration of spending cuts have immense potential economic ramifications. According to the Congressional Budget Office, if all of the adjustments simultaneously commence, U.S. GDP will contract by $719 billion, or minus-4.5 percent. For a country struggling to grow at 2 percent, such a contraction would put us firmly back into negative growth rates, and likely, recession.
While one can hope that common sense prevails and leads to a balanced, steady reduction in the deficit, we must be prepared to deal with the consequences of a variety of fiscal outcomes. Both sides seem to agree that we need to soften the blow of the scheduled fiscal cliff at year end, as well as the need for a longer-term solution. That is, unfortunately, where the agreements between the two parties appear to stop.
Under a divided government, only political compromise can avert the full brunt of the fiscal cliff. That could limit the contraction in GDP to approximately minus-1.7 percent, as certain elements set to expire would be extended while some cuts set to commence would be repealed. Again, an economy struggling to grow at 2 percent does not have much surplus capacity to absorb a 1.7 per-cent contraction. Our best-case scenario is that a compromise will be reached, but it will leave much to be desired and will do little to rectify the long-term fundamental and structural problems facing the nation.
Such a “mini-bargain” would significantly reduce the risk of a serious U.S. recession, but could lead to further debt downgrades. Eleventh-hour brinksmanship and theatrics to politicize the fiscal cliff will also have a deteriorating effect on both consumer and investor confidence.
Amid that uncertainty, we believe opportunities exist to prudently position investment portfolios to reduce the potential pitfalls of market turbulence and take advantage of global market irregularities. At the crux of the fiscal-cliff debate, the United States is on an unsustainable path of increasing federal debt and deficit burdens. The problem is magnified by unfavorable demographics as an aging population places additional stress on entitlement programs already on shaky ground. Opportunities exist abroad in countries that have debt, deficits, and demographics working for them instead of against them. Excluding most of Europe, China, and other troubled countries, sound investment vehicles exist in both emerging and developed countries.
Some common characteristics of these countries: strong federal balance sheets, the ability to lend money to other nations instead of borrowing, and a young and growing middle class unburdened by heavy individual debt. Countries such as Australia, Brazil, Indonesia, Norway, and South Korea share many of these characteristics.
A prudent way to take advantage of these opportunities is in the fixed-income universe. A 5-year Brazilian Treasury bond, for example, currently yields nearly 9.10 percent, compared to a U.S. 5-year Treasury yield of 0.7 percent. We are keenly aware of the additional risks associated with international investing, but a fundamental economic comparison between the two nations suggests that Brazil should not have to pay a premium of nearly 13 times that of a similarly dated U.S. Treasury.
Investors willing to look abroad for fixed-income opportunities in countries that have avoided the fiscal pitfalls of the U.S. will continue to be disproportionately well-rewarded for the risk taken.
Here at home, real progress on taxes and entitlement programs could remove at least some of the headwinds holding back growth. In the long-run, the fiscal problems facing America require budget reform so that our system of government can once again be a key competitive advantage rather than a growing economic disadvantage.
The 2012 elections left a divided government well-entrenched. This election is not a panacea for our fiscal problems; better risk-adjusted opportunities exist abroad for the time being.
James Battmer is chief economist and lead portfolio manager at Bukaty Companies O'Renick Wealth Management in Leawood, Kan.
P | 913.338.5300
E | jbattmer@bukaty.com