One of the more disturbing memories of the 2012 presidential campaign was hearing former President Bill Clinton's speech at the Democratic Convention. Mr. Clinton is an engaging speaker and his oration was nothing short of mesmerizing to the attending delegates.
Sprinkled amidst the fiery address were numerous statistics and figures presented by Mr. Clinton during his presentation. Naturally, this caught the attention of the fact-check crowd, but the task of verifying each claim or figure was according to FactCheck.org a "nightmare".
Efforts from other journalistic pundits to find errors found themselves with little to write about. Most agreed Clinton's speech was a bit too long. Aside from the usual rhetorical embellishment on issues of policy and finger-wagging disdain towards the current GOP regime, his statistical references were closer to the truth than not.
However, one statement Clinton made late in his speech failed to attract much attention from the media:
People ask me all the time how we delivered four surplus budgets. What new ideas did we bring? I always give a one-word answer: arithmetic. (See section of transcript where Clinton discusses the debt).
For anyone remotely familiar with unified budget accounting, hearing the word "arithmetic" uttered from Mr. Clinton's lips would be akin to being on the wrong end of a sawed-off shotgun. (Note: a primer on the Federal Budget can be viewed here.)
Clinton's so-called budget surpluses relied heavily on using trust fund surpluses (Social Security) to hide federal funds deficits. Thus, by using shifty accrual accounting, intra governmental holdings (supposedly off-budget) were added to give the appearance of a budget surplus. For example, according to a CNN story published in 2000:
The federal budget surplus for fiscal year 1999 was $122.7 billion and $69.2 billion for fiscal year 1998. Those back-to-back surpluses, the first since 1957, allowed the Treasury to pay down $138 billion in national debt (Wallace 2000).
Authors Sita Nataraj (Occidental College) and John B. Shoven (Stanford University and NBER) in a 2004 research report titled "Has the Unified Budget Undermined the Federal Government Trust Funds?" suggest otherwise:
More accurately, however, the total federal debt did not fall in either 1998 or 1999. The publicly held debt fell because the government was using the trust funds surpluses to finance its operations. This resulted in an increase in debt held by the trust funds, which more than offset the reduction in the publicly held debt. (See page number 8 using report link above.)
Implications: If the trust fund assets are to be viewed as "real" assets in any meaningful sense, then government debt held in the trust funds represents a real liability for taxpayers. The report goes on to say:
That is, from an accounting perspective, the trust funds cannot be treated as assets by the programs they finance unless a corresponding liability is acknowledged. The unified surplus fails to acknowledge such a liability by treating the trust funds' net income as money that is available to spend on other programs or rebate to taxpayers. (See page number 8 using report link above.)
The political implications are far more nefarious as the Clinton budget "surplus" era was equally embraced by the Republicans. Both sides of the aisle bought into this as though it were a "Grand Bargain" of some sort. To any politician, "surplus" is music to their ears and likely constructive to getting re-elected.
Understanding what happened requires understanding what constitutes national debt. The national debt is made up of public debt and intra-governmental holdings. The public debt is debt held by the public, normally including things such as treasury bills, savings bonds, and other instruments the public can purchase from the government. Intra-governmental holdings include the line items from which the government borrows money from itself (Social Security, Medicare, etc.).
Looking at the makeup of the national debt and the claimed surpluses for the last 4 Clinton fiscal years, we have the following table:
Table provided by www.craigsteiner.us
You will see that while the public debt declined in the four years 1998-2001, the intra-governmental holdings increased at a larger pace. Thus, the total national debt (public debt + intra-governmental holdings) increased and hence the discrepancy.
As anyone in the private sector realizes, there is a huge difference between a budget and actual results. The former is an objective while the latter is the outcome. If any private banker were to treat trust fund deposits as income and profit, they would face criminal charges.
For investors, understanding this distinction and the associated political risks involved will be helpful in positioning your portfolios in advance of any "Grand Bargain" scheme emerging from Capitol Hill. Aside from the political reality making a strong argument for term limits, how can investors prepare for a Fiscal Cliff scenario? Here are a few ideas we are considering in our portfolios:
Increase Cash Weighting: Sitting on cash is not sexy or profitable, particularly in a near-zero interest rate environment. But, as a tool for capital preservation, there is nothing more comforting than knowing you have dry powder.
We plan to up our cash allocations from 15-20% currently to 35-40%. This assumes a 30% chance that any substantial framework to a budget plan will be offered from a lame-duck session before year-end.
Avoid US Treasuries and Agency Debt: Even if a Republican held Congress agrees to any budget deal, implementation would be deferred to the incoming session next year, if not longer.
House Speaker Boehner has to know there's a grenade in the room and it's a matter of what sacrifices he and the GOP will make to see a deal get done. If he falls on the grenade in a spirit of compromise (not likely), investors will want to keep a close eye on who pulls the pin beneath his belly.
Regardless, budget impasses give bond markets indigestion and a back-up in Treasury yields would likely smoke a lot of bond investors out of their holes.
Diversify into non-US dollar denominated assets: Although the US dollar is perceived as a global reserve currency, the value of the dollar may be less desirable to foreign holders based on the belief that the currency is debased and/or the risk of becoming more so.
The euro currency too has structural problems, but there are other currency and non-dollar denominated asset pools for investors to consider. In the closed end fund universe, we will stick with Aberdeen Asia-Pacific Income (FAX), Western Asset Worldwide Income (SBW) and Strategic Global Income (SGL).
Equities: In the event no budget deal is forthcoming, equities could go into a free fall. In fact, if history is a guide, it might take a stock sell-off to spur lawmakers closer to a deal. Quantitative easing may well have been the catalyst to lift equity prices thus far, but a politician isn't likely to hear your cries for help until it's almost too late.
Whether that requires we go over the fiscal cliff first won't really matter. It's the kicking the can down the road mentality of our political leadership (set in place years ago) that investors should be concerned with most.
In either scenario, small and mid-cap stocks may be the most susceptible to selling pressure. Large-caps, particularly US based multinationals would not be immune to a broad based selling frenzy either. In a market correction defensive is relative, but we would be inclined to stick with our core holdings Pfizer (PFE), Merck (MRK), GE and even an Intel (INTC) if not just for the dependable dividend(s) and relatively stable balance sheets.
In the energy sector, natural gas E&P stocks remain attractive, with Cimarex (XEC) our favorite name in the space. We also plan to keep First Trust Energy Infra. Fund (FIF), a closed-end fund with exposure to downstream energy infrastructure. FIF yields 6.31% and also trades at a -6.78% discount to net-asset-value.
Fixed Income: The high yield universe has thrived due to a protracted low interest rate environment. Until at which time we see a move to tighten rates, demand for high yield securities should remain healthy.
However, demand has all but gobbled up the supply of pooled (i.e. closed-end portfolios) high yield products. As a result, debt premiums (particularly in corporate debt) are in excess of par and duration/maturity spans have shortened significantly. In short, there is little value and as current supply gets called in or redeemed, any new supply going forward won't offer coupon equivalence.
We still favor the variable rate senior loan area and one closed-end fund we own is First Trust Senior FR Inc II (FCT). Senior creditor preference is the main attraction.
Conclusion: These suggestions are only presented as an outline to how we (as investors) might prepare for the "Fiscal Cliff". This is not an indictment of the Clinton Administration, Democrats, Republicans or President Obama. However, it does speak volumes to the indolence within the political process in the US.
Unfortunately, the political reality is that the rules of engagement practiced by the folks we elect to represent our interests may be tone deaf to what those interests are. To hear Bill Clinton imply that his budget "surplus' is an example of prudent fiscal stewardship may be clouded by accounting gimmickry. To advance this as "status quo" would be harmful to any meaningful fiscal outcome going forward.
Investors should hope for the best but be prepared for the worst. Although Obama clinched the electoral votes decidedly, the amount of popular votes that prevented Romney from capturing more of the electoral count was razor thin. This was a very close election and quite revealing to the polarity amongst voters.
Ultimately, some fiscal deal will be reached, but investors who pay attention to the "arithmetic" can position themselves to hopefully avoid a lion's share of pain that is likely to follow.