Let the Games Begin!!!

The political games on the Federal budget have begun.  Over the next few weeks, there will be a lot of political posturing on both sides.  Republicans are complaining that the budget proposed by President Obama (adding $7.2 trillion to the deficit over the next ten years) doesn’t even scratch the surface.  Democrats are complaining about how draconian the $30-$60 billion in cuts the Republicans have thus far proposed are (this out of a $1.65 trillion deficit this year).  The fireworks will continue over the next few weeks as the debt ceiling limit vote needs to be taken before March 4^th.  The posturing may be fun (or sickening) to watch over the next few weeks, but the direction of the Federal budget isn’t.

We at THOR have been consistent in our thoughts on government spending.  Yes, it is too high. However, in a severe recession like we just experienced, the government should spend more and go into debt in order to spark economic growth.  We have also been consistent in that the government must reduce spending when the economy comes back because run away deficits are not good for anybody’s financial health.  After the economy came back in 2003, President Bush made the fatal error of not reining in (vetoing) spending bills.  By not reducing spending, the deficit continued to grow at a time when it should have been falling as the economy came back and tax receipts rose.   We believe we are at the same critical junction now and believe that the government has to take their foot off the gas pedal and apply some spending discipline.  If it fails to put the brakes on spending, the bond market will.

Many parts of Europe (Britain, Ireland, Greece, etc.) are taking austerity spending measures.  The politicians in these countries would rather spend money, but they have to take these measures because the bond market is making them.   What do we mean?  The bond market not only tells you the vigor of an economy, but also tells you the health of a governmental entity.  The more risk of default, the higher rate of interest one must pay in order to entice investors to buy those bonds.  That is why the states of California and Illinois pay a much higher interest rate on their bonds then North Dakota does.  Our government will need to borrow an additional $1.65 trillion this year to fund spending.  If investors believe that there is a risk of default or inflation, they will demand a higher rate of interest when buying those bonds.  We have already seen this happening as interest rates on government notes have risen in the past few months.   The 5 YR Treasury Yieldhas risen in just the past three months from 1.04% on November 4^th to 2.35% today.  The 10-year US Treasury Yield has also risen from a low of 2.33% on October 8^th to 3.61% today.  Part of that rise is because the economy is doing better.  The question is how much of the increase is due to a lack of confidence in our government?  We think it could be greater than many analysts think.  Why?  Because this rise in interest rates has occurred during QE2 (Quantitative Easing 2) when the Federal Reserve has been buying $100 billion a month in US Treasuries (which now makes the Federal Reserve the largest holder of US debt, even more than China).  We think rates would be much higher today if the Federal Reserve wasn’t buying US Treasury Bonds.  Whether it is through Congress and the President or through the bond market, spending will have to be curtailed.  It would be best for all if the politicians did it before the bond market dictates those changes.

Sincerely,

Your THOR Team

P.S. – We want to make you aware that Jim has earned his Chartered Market Technician (CMT) designation (www.mta.org) and we wish Neal luck as he sits for the Certified Financial Planning exam in March.

Egypt – WHAT NEXT?

The unrest in Egypt is causing jitters around the world as investors ask – what next? First, we have to look at the main reason for the uprising in both Tunisia and Egypt. Both of these governments have been authoritative for years with repressive governments and high unemployment. So the question is why now? In our opinion, the big reason for the uprising is higher food prices. This inflation has been occurring for several reasons: easy US monetary policy (because commodities are priced in US Dollars), growth in earnings in emerging markets causing greater demand for food, and a drought in Russia that caused it to halt any exports of wheat out of the country. So Egypt, with their desert and inability to grow crops for all their people, is suffering more than others because of rising food costs. People are hungry. Brazil, India and China are also experiencing food inflation and all three have raised interest rates in the past few weeks to curb inflation and avoid social unrest. This action is having an impact in those countries as their respective stock markets have fallen in value since November. The US stock market has advanced during this same time.

We do not yet know the outcome of the unrest in Egypt, but we are watching closely how it unfolds. Will they go the route of Turkey (democracy) or Iran (theocracy)? Egypt is more secular than Iran and has a highly educated populous and, we believe, the populous will turn the government into looking more like Turkey than Iran which would be a good outcome for Egypt. However, the certainty of that path is unknown as of yet. If it goes the other way, we will be looking at those ramifications and adjusting our portfolios accordingly. In our last update, we mentioned that we thought the stock market was overbought. The correction last Friday did help to alleviate some of that froth, but in our opinion, investor sentiment is still too positive – which is negative for the stock market. Some more froth needs to be taken out of the market and we believe Egypt could be a reason for that lack of investor confidence.

Sincerely,

Your THOR Team