Default Averted: Good News For Washington Not So Much For Investors

02 Aug

Washington was able to finally come to some semblance of an agreement over the country’s debt crisis and avoid a catastrophic national default, for now. The agreed upon plan saves us from the default now but still leaves most of the hard work yet to come. The plan itself doesn’t do anything to alleviate concerns of investors that were already growing. The stock market opened high after the announcement that a plan had been reached, but fell almost immediately. Details of the plan suggest to investors that growth in the future might be a bit too optimistic and is in turn keeping investors from committing money into the volatile stock market. The article below details the plan the government has passed as well as sheds some light on potential investor concerns that come from that deal.

Debt deal doesn’t clear the way for growth and returns. Quite the opposite.


Monday’s stock market tape said plenty about what the new debt deal means to investors. The Dow Jones Industrial Average opened more than 100 points higher in celebration of word from Congress that it would narrowly avoid a U.S. default. But that’s like cheering a boxer for not punching himself in the privates, investors soon realized, and stocks slipped into the red before lunchtime.

The problem isn’t the deal itself. True, it’s a compromise so meager that it makes Friday’s passing of House Resolution 2244, naming a New York post office after a Vietnam War hero, look daring by comparison. The deal imposes almost no spending cuts over the next two years and thereafter slows but doesn’t eliminate the rise in the debt, and it leaves work on the difficult parts — tax and entitlement reform — for later. But it avoids default today and forces lawmakers to get serious in coming months about some long-ignored problems.

It doesn’t do anything to change two of the biggest forces that will drive investment returns in years to come, however. The first is that, just as wanton borrowing has flattered economic growth in recent decades, prudence must now crimp growth. The second is that a demographic bulge that spent a quarter-century stuffing pay into shares and bonds will now begin cashing these assets in, and the effect on prices isn’t certain but is unlikely to be positive. Next to these two factors, remaining concerns, including the continued risk of a U.S. credit downgrade, seem trifles.

The naked economy, stripped of its deficit spending, isn’t pretty. Gross domestic product per head has increased 6% over the past decade, but take away for the amount by which public debt has swelled and the result is a 6% drop in GDP, wrote Rob Arnott or Research Affiliates in an April newsletter to clients. The real economy, absent population growth and borrowed puffery, hasn’t improved since 1998. That suggests that if the nation spends within its means, or beyond them by less, as seems necessary, the result will be a long economic slog.

Ultra-low interest rates have forced a quick bounce-back for stock and bond prices, but they can’t force a return to dependably rich long-term returns. The first of 79 million baby boomers turns 65 this year. The mutual fund industry, with its $12 trillion of stock and bond assets, grew up around boomers like the trade in relaxed fit jeans. A retirement wave might thus set off a long decline in stock demand as boomers spend part of their savings.

The Government Accountability Office studied the matter in 2006 and concluded there’s little to worry about. “The small minority who own most assets held by this generation will likely need to sell few assets in retirement,” read its report. But that’s another way of saying that most boomers are broke. If the GAO is wrong, stocks may disappoint. If it’s right, the retirement and health care needs of low-savings boomers will create a drain on the public purse, leaving less for private investment, and stocks may disappoint.

There’s no doomsday on the horizon, as much fun as it would be to prepare for one. There’s not even necessarily a crash. But there’s likely to be a long period of challenging conditions for investors. The 18% average real returns (after inflation) of the 1980s and 1990s are as over as M.C. Hammer pants. The 7% real returns of the past two centuries look optimistic, too. Cal Tech economist Bradford Cornell won a Graham and Dodd Scroll Award last year for a paper published in Financial Analysts Journal. In it he argued simply that stock returns are inevitably driven by economic growth, and that economic growth in the U.S. is sure to slow. Investors should thus expect real long-term stock returns of about 4% a year, in Cornell’s view.

If he’s right, investors might want to make some adjustments to their portfolios. Dividend yields average a measly 2% at the moment, but there are plenty of 3% ones to be found, and in a world of 4% stock returns, a 3% income is plenty attractive. Second, a big price drop is a difficult thing to come back from at a pace of 4% a year. That makes preserving capital as important as trying to spot the next big score. Giant U.S. companies are out of favor, with many trading for cheap andcarrying decent dividend yields, I recently wrote. Companies like Exxon Mobil(XOM: 78.19, -1.41, -1.77%), Microsoft (msft), Johnson & Johnson (JNJ: 63.69,-0.72, -1.12%) and AT&T (T: 29.30, -0.22, -0.75%) sell for around one-third less than the broad market based on earnings, and pay 2.3% to 5.9%. Sexy they aren’t, but companies like these can keep the cash rolling in during lean years, and a string of those seems all too likely.

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