To The Max: Economical Letter

I wanted to share this letter written by Covington Capital Management, to relay the major impact this deficit has on our economy. I believe it is important for all of us to understand the affect it has not only on our country and how the government is handling the situation at hand, but specifically to the students, and the future of this country. I know its really long but its important to understand, enjoy!

Conversation starter: Why do you think the U.S. the most powerful country in the world (that has the ability to pick and choose leaders for other countries) cannot find a substitute for oil, when Brazil has converted 100% to ethanol?

This is a letter about understanding the endless and puzzling debate on taxes, debt, government budgets, and the broad role of the public sector in our economy. We are all responsible for our own views and most people try to make informed judgments and vote intelligently. These choices have huge investment implications. The logic strings are often tangled and hard to follow, but clearly this is an important time to pay attention. Many believe that the U.S. government is broke and no one wants to admit it.
First , it is important to understand who is responsible. If we have high deficits, inflation, weak currency, wars, etc., the U.S. Constitution makes it clear that control lies in the power of the President proposing the Federal budget and the House of Representatives decides appropriations. Congress is responsible for the tax code and fiscal policy. Congress delegated to the Federal Reserve Board control of monetary policy and responsibility for a sound currency. These institutions of government and all political parties tend to deflect blame for mistakes and pound their chests for triumphs. They seldom let voters know that one hundred years ago, the U.S. was the most prosperous nation in the world, taxes as we now know them did not exist, we had not national debt, we had the largest middle class in the world, and moms stayed home to raise the kids. What happened—can you spell politicians?

Here is a random sample of some of the important ingredients of the tax, debt, and government budget puzzle: players- individuals, corporations, lobbyists, unions, government entities; consequences-individual responsibility, social programs (i.e. education/health care), income redistribution, borrowing from the future, inflation; international consequences-status of the dollar, trade imbalances, armed force readiness; entitlements- unfunded pension liabilities, municipal/state indebtedness, private vs public interests, government home purchase help. Just samples, the list is endless.

A first metric to watch regarding the Fed budget is the debt vs, the GDP. According to Fed Chairman Bernanke, nations with a debt-to-GDP ratio between 60% and 70% (like the U.S.) are pretty comfortable but going over 100% would be very concerning. A second metric is the level of absolute or relative tax rates  both for corporations and individuals. California and a number of other states seem to have found tax rates that cause residents and businesses to migrate out of state or simply fold.
Question: Should world class companies be treated as precious resources or should they be strip-mined for taxes to pay for unsustainable and inefficient government?
A number of blue chip companies have moved significant operations, out of the U.S. to be nearer drivers of future growth and to lower their taxes.

The management group compares the U.S. economy with Argentina and Chile to foreshadow what could happen to our country. Both countries are blessed by nature in terms of resources, arable land, climate, etc. Both are populated by people of European extraction overlaid by a Spanish Culture. Chile Leads Latin America nations in human development, competitiveness, income per capita, economic freedom, and a low perception of corruption. The percentage of Chileans with household incomes below the poverty line is less than 14%. Sound economic policies, maintained consistently since 1980’s has been crucial. Public debt as a percentage GDP is minimal, and far lower than the U.S. Argentina is a wonderful country, self sufficient in oil, a leader in important farm products (they are the biggest producer in soybeans which they export to China to feed their pigs), but economically a serial disaster. Between 1880 and 1929 Argentina  was one of the ten richest countries in the world. Since that time, bad political/economic leadership has led to falling living standards, record foreign debt, patronage, and corruption bouts of massive inflation, currency collapse, periodic capital flight, protests, riots, frozen bank accounts, high rates in poverty and unemployment, and serious decline in the quality of public education. Argentina’s nanny state contrasts sharply with Chile’s emphasis on small government, minimal regulation,  and emphasis on individual initiative.

The decision-making in Washington is important and has direct investment implications.  The wealthy in Argentina have permanently moved a lot of capital outside their country. Our politicians need to recognize there are limits to levels of debt, size of government, the government’s effectiveness as a business manager, and the level of taxes that can be reasonably enacted without adverse economic consequences.
Another obvious implication of negative debt/tax/budget trends is on the attractiveness of long-duration bonds. The long bond rally since 1980 is probably over. The largest manger of fixed income debt in the U.S. is Bill Gross of Pimco. he has traditionally been a large holder of the U.S. Treasury obligations. Not any more. They have sold all Treasuries and are currently shorting them. Gross believes the U.S. debt situation is so far out of hand that unless entitlements are reformed, the country will default on its debts not in conventional ways, but by picking the pockets of savers via a combination of inflation, currency devaluation, and low to negative real interest rates. Conclusion: stay out of long-duration bonds.

In summary, solving our problems requires tough choices. Many believe the U.S. government needs to promote a stable economy, reduce entitlement spending, and understand that excessive debt is a bad word. Congress so far prefers the status quo and to kick the can down the road. If investors do not believe effective action is or will be taken, investment norms of the past in terms of asset allocation, bond investing, foreign versus domestic mix, need to be revised.