It has become fashionable to compare the U.S. fiscal situation with that of Portugal or Greece. Forgotten, though, is that the U.S. has no foreign currency liabilities; it is the only government that can issue claims against itself. As such, there is no sovereign risk on U.S. government debt. In theory, the Federal Reserve can buy all the outstanding debt it wants by issuing dollars, with the only limitation being how much inflation it is willing to create. Therefore, there should be zero sovereign risk premium in U.S. government bonds, although there can be plenty of inflation risk in the market. Politicians may not understand the subtleties of the interconnections between debt, sovereign risk, the reserve currency and the global savings-investment balance. It is popular to be fiscally conservative and austere, even though there is a glut of excess savings (e.g., China, Germany, and Brazil) around the world. The risk today is that fiscal policy becomes too tight, jeopardizing the economy and interrupting the bull market.
Financial markets remain in ‘risk on’ mode, shrugging off concerns about Japan, the Middle East and North Africa, as well as peripheral Europe’s stubbornly unresolved fiscal crisis. The S&P is hovering just below its post crisis peak; oil, gold, and other commodities are at new highs; and the U.S. dollar has broken down against the euro and Canadian dollar. While gathering momentum in the U.S. jobs market, has fed a growing confidence in the expansion’s ability to sustain itself, investors may be confronted with some disappointing data in the near term; high oil prices and fiscal tightening are bound to take at least a small toll on spending.
The corporate bond bull market may be making a quiet transition to a new phase characterized by slower credit tightening and perhaps higher Treasury price volatility. Such a transition is rarely obvious in advance. Only in hindsight can investors realize that the market trend has changed pace. U.S. stocks are being buffeted by two opposing forces:
- A strengthening U.S. economy, low interest rates and a much cheapened dollar are propelling stocks higher
- High and rising oil prices, fears concerning Japan’s nuclear disaster, higher commodity prices, the prospect of fiscal austerity (Obama’s $4 trillion, 12-year plan to cut the budget deficit) and fading policy support are all working to stall the market’s advance
Overall, the equity bull market, which began in March 2009, remains intact, but the investment environment has already become much more challenging than before. Investors need to reduce their return assumptions and expectations and be prepared to embrace more price volatility. We believe that QE2 (the Federal Reserve’s quantitative easing plan) will end without creating much commotion in the marketplace or the economy, although on the margin, the end of QE2 is a negative or restraining force on the market.
A potential concern is that the markets, and especially oil, are influenced by non-economic forces such as socio and geo-politics in particular. For example, King Abdullah of Saudi Arabia is close to 88 years old and in frail health. Although the king is revered by the Saudi people, the same cannot be said about his brothers, who are also well over 80 years old. The eventual death of King Abdullah would almost certainly stoke fears of social unrest in Saudi Arabia, creating enormous upward pressure on oil prices. In addition, Mideast turmoil and political infighting continues in such oil sensitive countries as Libya, Bahrain, Egypt and Iraq as well as Syria and Lebanon. Stocks would take a serious beating and bond spreads would widen (which is negative for their prices) if oil prices spike above $150 per barrel.
Michael Ashley Schulman, CFA
Hollencrest Capital Management