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People are being inundated with media reports about the impending "draconian" automatic spending cuts that just went into law and will kick in over the next 10 years. However, the stock market showed no visible panic during this fire drill in Washington. Many investors I speak to want to understand "should they fear or applaud the spending cuts with respect to their investments?" After all, it is easy to try to imagine that if a government service must be scaled back to meet the law (not withstanding that the scale back may just be a lower reduction in increase), surely this is a drain on the economy which will work against stock valuations in some way - right?

Well, at the present spending levels of the U.S. Government, the evidence points to the fact that the opposite is much more likely to actually be true with respect to U.S. economic growth as measured by GDP. And since GDP is a major factor in the overall stock market valuation such as the S&P 500 (NYSEARCA:SPY), spending reductions at present should flow through and be a positive for stocks in the future.

The National Debt Data

The empirical evidence that I track shows how National Debt levels accumulated by the U.S. since the 1970s crossed the optimal level for the economy in the early 1990s. The National Debt has since grown to a level which hinders the ability of the nation to actually produce anything but slow growth of 1% GDP. My data is consistent with academic research by Carmen M. Reinhart and Kenneth S. Rogoff [1], who have studied this issue across many advanced economies through history.

The chart below details the percentage of debt to GDP (in constant dollars) from 1970 to present. The chart shows that the national debt outstanding has grown to over 100% of U.S. current year GDP.

During 1970 to 1982 the debt as a percentage of GDP was falling to a multiple decade low after peaking post WWII. Since the mid-80s debt began to build-up again. The country ran a federal budget surplus only in the year 2000. During the remaining years it has run deficits.

(click to enlarge)

The second line on the chart shows the trend line of real GDP from January 1970 thru December 2012. This line shows the U.S. GDP level year over year through the time period. To smooth out the impact of 4 year business and political cycles, I have used a 48 month moving average.

The GDP data trend line relative to the overall debt as a percentage of GDP is what an investor needs to pay attention to. The U.S. in recent history has demonstrated strongest growth when it is "levered" from between 35% to 60% of GDP. When in this range, 2%-5% real GDP was routine performance, with the exception of the period in the late 70s to 80s. In this time period there were other contributing factors to declining real growth, primarily excessive inflation and real interest rates being held below inflation.

The country's ability to produce high GDP once the debt level exceeded 70% of GDP has been a problem. The trend-line of GDP growth as debt levels increase has declined significantly as more debt is taken on by the U.S. GDP has steadily declined through the late 90s and been acutely low since 2006, showing no real growth increase with major government spending increases in the 2009 time period to present.

A Restructure Needed - And Happening

Just as a corporation with excessive debt must sometimes be re-organized in order to realize the highest and best uses of its resources, the data suggest the same is needed in the U.S. government. This is actually in progress now, as witnessed in the back and forth in Washington. But the data suggest the reversal to sustainable economic growth requires very large spending reductions relative to GDP to get back to the optimal target range - just as happened in the late 1940s to the 1980 timeframe. Reductions are likely to take place gradually.

How is the "Re-structure" Affecting Markets

Increased Taxes - Almost everyone saw an increase starting January 1st this year. Not many escaped. This will be a drag on GDP growth throughout this year and beyond and likely to hurt consumer discretionary stocks most.

Sequester Spending cuts both Military and Discretionary - These cuts should have a positive impact on the overall stock market valuation because they begin returning the trajectory of spending to a more optimal level. However, as with any change, a decrease in cash flow to a particular sector or company will show negative impacts to unique stock prices. Near-term the reduction in military spending will be a drag on the defense sector.

Repressive interest rate policy - Everyone who is currently purchasing a CD, savings account, U.S. Treasuries, example (NYSEARCA:TRSY), and most credit instruments which are dated out to 10 years maturities is paying an "implied" tax - where they granted the right to lose real purchasing power if they hold these assets long term because they do not keep up with inflation. Interest rates on money borrowed by the government are being purposefully held below inflation. Continuing this policy over time is intended to lower the overall balance of the U.S. debt relative to GDP as long as there is inflation by lessening the interest paid by the U.S. government on the debt.

Portfolio Investing in this Environment

Federal policy is forcing investors into riskier assets to achieve positive real returns. Unfortunately, people are saving money for a purpose and need it in the near to medium term are being hit with an inability to even keep up with inflation with most investment products they have available to them. The U.S. fiscal policy and the Federal Reserve are becoming more in sync to return the national financial situation to balance which makes equities more attractive. So equity asset should be the place to invest - right?

For most investors, bold new plays in equities at current valuations are probably not a good idea. The U.S. restructure in Washington is a battle that will go on for some time - and it definitely does matter to your investment strategy. Problems will be encountered as this Great Experiment continues and will only drive equity and bond asset prices to become more volatile. New highs will be greeted with increasing volatility, and may unravel on the whims of a disgruntled voting electorate - not fundamentals. The tax increases implemented and Healthcare Bill are major headwinds this year. Slow economic growth, combined with a monetary policy encouraging inflation will likely increase market volatility, even with the Fed's backstop. Interest rates, although normally much higher when loose monetary policies are being implemented, will not be allowed to rise in the Treasury and banking market. Bank lending will stay restrained because of repressive rates.

Best Strategy:

  1. Review Duration: Match the duration of your entire portfolio to the date(s) in which you expect to need funds.

  2. Rotate some cash: Some percentage of your investments that are in cash-equivalent savings may need to be re-deployed just to preserve buying power overall in your portfolio. If you use this strategy, search for intermediate-term credit based investments that can produce near equity returns if held to maturity. One such strategy would be to buy investment grade callable bonds with higher than market coupons that are trading at or near par.

  3. Accumulate Hard Asset inflation protection in your portfolio: Assets such as income producing real estate and oil are two places I would look for value opportunities. The oil market is presently in a pullback due to the U.S. currency strengthening relative to other world currencies. This trend is unlikely to last as the Fed really ramps QE3 this year, which according to the Cleveland Fed data has not yet begun in earnest.

  4. Maintain a "get paid for investing" mentality for any equities you buy: Choose stocks so your money can be re-cycled to other alternatives as market conditions change. For pure equities, this means search for companies with a high dividend coupon which is expected to be maintained and grow through time.

[1] A Decade of Debt, Carmen M. Reinhart, Kenneth S. Rogoff, NBER Working Paper No. 16827, February 201

Source: The Sequester - Why No Wall Street Panic?