Everybody Wants Some

Ooh, everybody wants some!
I want some too (Oh yeah)
Everybody wants some!
How about you?

by Van Halen  - Everybody Wants Some Zombieland song HQ

Last week, at literally the eleventh hour, our government agreed to make a massive dent in our budget deficit. They agreed to cut $39 billion, or a whopping 1.02% out of our $3.82 trillion pie. 

Here is a superb visual of what 1.02% of a $3.82 trillion pie looks like..."Everybody wants some"...

OK, here's another view of where the money comes from and where it goes. The numbers are a little different then the pie above because it's a little dated (the pie is more recent), but it gives you a good idea of the magnitude of cuts that need to be made. 

Investment Implications: 

I'm not going to try and attempt to solve this nightmare, we've hired enough politicians for that job, I'm just going to try and look at some probable investment implications.

The politicians will address this problem on the revenue side and the spending side. 

First, Revenues. The Democrats will try and raise taxes on the wealthy (you know who you are), keep corporate taxes relatively stable, and maybe eliminate a few loop-holes. The Republicans will try to keep individual tax rates the same, lower corporate taxes, eliminate loop-holes, and try and grow the revenue pie through a growing economy. Likely outcome: Since over 50% of the population pays no net taxes, and the top 10% (over $150,000) pay 71% of all taxes, the votes of the 50% will win out over the votes of the 10%, and tax rates for the wealthy (YNWYA) will go up. Corporate rates might actually go down, and with an elimination of many loop-holes, revenues might actually rise a bit.

Overall the key to rising revenues will be GDP growth above 3%, without GDP growth anything the politicians tinker with will make a minuscule difference.

Spending. This is where the real battle will be waged. Both sides will try and ax the other sides pet projects, and there may even be some headway made on reigning in the big three entitlement packages; Social Security, Medicare, and Medicaid. But if last weeks budget episode is any indication of how successful they might be, don't expect serious change in the next two years.

The debt is the real problem. When you constantly spend more than you take in your debt burden balloons (Currently over $14 trillion  http://www.usdebtclock.org/ ). When you are deeply in debt you basically have two options for getting out of debt. One, generate more revenue than you spend, and pay down the debt. Or two, default on the debt.

Clearly option one, paying down the debt with excess earnings, is the preferable option, but in the case of the US it is also the least likely outcome. Option two, some form of default, is by far the most likely scenario, and is actually occurring right now.

Default - How the Government Defaults on its Obligations. When most of us think of defaulting it usually means not making any more payments on our debt. While this could happen on the governmental level (Argentina or Zimbabwe) it would be highly unlikely for the United States. What is much more likely is what is already going on, a combination of austerity and inflation. 

Austerity is a form of default, because the government is reneging on its promises. Changing the ages of Social Security recipients, means testing Medicare, slashing physician reimbursements, are all just forms of default. We promised you one thing, now we're changing it. The problem with this type of default is the people (aka voters) hate having their promises reneged on. They tend to get very nasty and vote for someone who will promise them some more pie. Austerity is and will continue to happen, it will just happen in those areas where there are the fewest voters (read, wealthy). As we can see vividly in Greece, Ireland, and the UK, deep austerity moves take a tremendous amount of political will and leadership, which is something we here in the US are certainly lacking. 

A more insidious and benign form of default is inflation. By devaluing their currency a government is paying back their debtors with cheaper dollars. This is especially true if the central bankers can convince the bond market that there really is no inflation, so interest rates are below true inflation. Real negative interest rates transfer assets directly from savers to central bankers. The problem we in the US have is that we are not alone in our quest for the lowest valued currency. The US, Europe, and Japan represent 60% of the World's GDP and all are seeking the same remedy out of their untenable debt. No central bank starts down this inflationary path with the goal of hyperinflation and default, they look at inflation as a way to pay back less than they borrowed. But sometimes it doesn't work out that way (see, Germany's Weimar Republic, and Zimbabwe), sometimes the debt holders refuse to play along. Tiring of getting paid back in more and more worthless currency they decide not to loan you any more. When that happens things spin out of control very quickly, almost overnight. What is deeply troubling about our current situation is that we have 60% of global GDP all trying to outdo each other on the downside. One thing that we have going for us is that the US dollar is the worlds global reserve currency, unlike the Yen and Euro. Our biggest weakness though is that most of our debt is held by investors outside of the US, namely China and Japan. Here's what Yu Yongding, a former advisor to China's central bank, said this week, "China should retreat from the US government bond market and instead allow the Yuan to appreciate more freely. US sovereign debt is akin to a giant Ponzi scheme."

Of course we are all aware of these issues. The US government (including the Fed) is playing a giant game of chicken with our debt holders. In most games of chicken one side or the other will blink and catastrophe will be avoided, but in this game are we putting too much faith in our decision makers to do the right thing? 

An old saying in the short-selling profession goes like this: People always underestimate how bad things can get, they are inherently optimistic. 

So while our esteemed decision makers play out their high stakes game of chicken, what do we lowly investors do? First, avoid all longer term government debt. Second, buy hard assets. Hard assets include gold, silver, diamonds, real estate, art, etc. Third, buy equities, especially those in areas of the world where money will run too. Fourth, buy consumable commodities that are rising quickly in our inflationary world (oil, grains, etc). Fifth, be ready to act, timeliness will be critical. And lastly, eat, drink, and enjoy your friends and family, that optimistic human spirit has served mankind well for thousands of years (even though it makes him a little blind at times).

Be careful out there, and keep the lights on,

Chris Wiles, CFA

412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:

www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.