Market Update: Muddling through ― the debt saga continues
William F. (Ted) Truscott, CEO, U.S. Asset Management & President, Annuities — November 23, 2011
We have been treated to some additional downside volatility in markets thanks to inaction in Europe and the United States. Debt, or more precisely how to trim sovereign indebtedness, dominates the headlines both here and abroad. Europe’s debt crisis has escalated as concerns have spread from Greece to Italy and Spain, two much larger countries. As I predicted earlier this year, the “Super Committee” charged with making recommendations to trim our nation’s deficit has also failed. I was never quite sure how this committee could reach agreement on the same set of issues that prolonged the debt ceiling debate in Washington, D.C., over the summer, and unfortunately those fears were not unfounded.
- Borrowing costs for Portugal, Italy, Spain and France are rising relative to Germany. This reflects the market’s perception that these countries are now riskier than Germany. The market is also testing the will of European leaders to defend the Euro.
- The Euro is the result of political and economic considerations. It will not be easy to abandon the Euro and an exit from the common currency could prove disastrous for countries such as Greece and troublesome or harmful for every other European country except Germany.
- Germany has much to lose if the Euro collapses as well and it is the failure of politicians to explain this to the German population that only exacerbates the situation.
- This debt crisis began more than 18 months ago and with each month of inaction the options become more limited. Right now the solution that seems most credible is to make the European Central Bank (ECB) a lender of last resort.
Why Europe matters
- Europe is a significant growth engine for the world. Most commentators believe that a European recession is now inevitable. This will only exacerbate a tepid economic growth picture for the world.
- Any write downs or losses taken on European sovereign debt will ripple through the banking system and eventually affect banks in the United States. While exposure to Greece is limited, this is not true for larger countries such as Italy and Spain.
- Anyone with a sense of history will look upon European social turmoil with some degree of angst. One of the many motivations for adopting the Euro was, after all, to bring Europe closer together and not drive its nations further apart.
- The “Super Committee” of congressional leaders from both parties was unable to come up with a plan to pare the U.S. deficit. This is widely described as a failure and that is exactly what it is — a failure of leadership and a failure to recognize that the national interest is more important than ideology or who wins the next election.
- The automatic spending cuts that will result could spark a recession. However, most of these cuts do not take place until after the 2012 election. The next Congress and president can easily undo these cuts. This, however, only prolongs our debt problem. As Europe has demonstrated, further dithering will only further constrain our options.
- U.S. debt has not been further downgraded. It will be, however, if we do not take steps to trim our deficit. This is a reminder that our deficit is the result of the lowest tax take since 1950 and the highest expenditures since World War II. A solution to the deficit must include both expenditure cuts and revenue raising measures.
- Colin Moore, Chief Investment Officer – Columbia Management, has repeatedly noted that our deficit problems are occurring at a time of extraordinarily low interest rates. A rise in borrowing costs will only make problems worse.
- The 2012 election will become a referendum on how the country chooses to handle the deficit. We do not have much time. Baby boomer retirements, interest on a mounting debt, and slow economic growth will result in exponential increases in debt by the end of this decade. By 2025, the United States fiscal picture could look worse than Greece does today. Approximately half of all our national debt is held by foreign interests. We do not want someone else controlling our destiny.
Portfolio considerations/potential strategies for earning a return
This situation will be with us for a while. I see no end to market volatility until the leaders of the U.S., Europe and Japan adopt policies that trim debt and spur growth. Here are some ideas that you can consider to help manage risk and try to earn a return on your money during this period of extraordinarily low rates. The links to specific Columbia funds and RiverSource insurance and annuity products that are included under the categories suggested below are provided to help you learn more.
- Dividend paying mutual funds are a must have. This can be a stock fund consisting of companies that pay dividends or investment-grade credit and high-yield bond funds.
- Columbia Dividend Income Fund
- Funds that can earn income by investing in both stocks and bonds (known as flexible funds) should also be considered in this environment.
- Municipal bonds continue to offer good returns despite some risk of municipal defaults. This is an effective strategy for earning tax-free income.
- Annuities that offer guarantees and lifetime income can help dampen downside portfolio volatility and provide a secure stream of income in retirement. (All guarantees are based on the continued claims paying ability of the issuing company and do not apply to the performance of the variable subaccounts, which will vary with market conditions)
- Life insurance also offers the potential for downside protection while generating income in a tax-advantaged way.
For more information about the risks associated with each fund, click on the links provided to view the prospectus.
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Non-investment grade securities, commonly called “high-yield” or “junk” bonds, have more volatile prices and carry more risk to principal and income than investment grade securities.
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There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.
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