2010Dec15 Operating with a deficit

 "The individual's power to operate something

 with a deficit is very limited."

Economic Policy-Thoughts For Today and Tomorrow: Ludwig von Mises

We are living in extraordinary times.   More often than not, politics are a distraction from the underlying factors that matter most, such as demographic trends and valuations. However, much of the market’s action over the past three years has been driven by or seriously influenced by decisions made in Washington, DC. We have had bailouts, TARP, quantitative easing (or guessing) and health reform. Just name any major factor that has driven asset prices and chances are good that it came from the halls of government, either domestic or foreign.

As investors, the relevant question is “what does this mean for the markets going forward?” Unfortunately, the answer is not easy. If the Federal government actually implements austerity measures, it should mean a slowing economy until the private sector recovers enough to pick up the slack. All else equal, this should be good for bond prices but bad for stock prices.

Of course, “all else” is not equal. Fed Chairman Ben Bernanke is attempting to pick up the slack in Federal fiscal stimulus by replacing it with monetary stimulus—i.e. quantitative easing (or guessing). All else equal, the Fed’s actions should stoke inflation, which would ultimately be bad for bonds but could be good for stocks in the short-term. 

Again, “all else” is not equal. Credit continues to shrink in the private sector faster than it is created by the Fed, meaning that deflation is still a bigger risk than inflation. This is good for bonds and bad for stocks.

The probable extension of current income tax rates should benefit household and business consumption. However, the 2% Social Security employee tax holiday creates $120 billion of new debt for a system already in deficit. It matters not whether the debt on the Social Security ledger or transferred to the General Fund. It is still an increase in our debt.

Suffice it to say, there are a lot of countervailing forces at work, though the evidence suggests that the economy is improving little by little. At this stage of the game, it is impossible to say how things will shake out.

As always, investors have to maintain a level head, keep emotions in check, remain flexible and take advantage of investment opportunities as they arise. Instead of guessing about next year’s outcome and placing an asset allocation bet, we will continue to look for developing and sustainable trends to hold in portfolios.