The Good, the Bad and the Ugly

In 1966 Jeremy Thomson wrote the classic western “The Good, the Bad and the Ugly” which starred Clint Eastwood.  The story goes that two cowboys learn of a buried stash of gold in a cemetery. The problem is that each one only has a piece of the critical location information - one finds out the name of the cemetery, while the other finds out the name on the grave. So the two must work together in order to find the gold.

During the summer of 2011 Washington politics can be characterized as The Good, the Bad and the Ugly as Democrats and Republicans argued, pontificated and blamed each other for the seemingly never ending impasse to get a comprehensive solution to the debt ceiling problem.  Much like the movie each side talked about working together but showed distrust of the other’s motives. 

Before the political pundits barraged airways with the drama playing out in DC, recall that Saddle Peak had, after extensive research, meaningfully repositioned the portfolio to reflect a more defensive posture. The substantial change in asset allocation was based on our (continuing) belief that Washington is broken and interest rates are too low.  

The Good: After much politicking an agreement was reached that averted the possibility of a US government debt default.  Highlights of the agreement follows:

•         Allows a debt ceiling increase by as much as $2.4 trillion dollars in total. A further increase of at least $1.5 trillion would be available only after a special bipartisan committee identifies matching levels of spending cuts.

•         Calls for cuts of more than $900 billion over a ten year period in spending from programs, agencies and day-to-day spending.

•         Calls for the formation of a 12-person bipartisan special committee to identify further spending cuts. Note that this committee must complete its work by Thanksgiving 2011 and Congress must hold a vote on the committee’s recommendations by December 23, 2011. Importantly Congress cannot modify the committee's recommendation.

•         If the special committee is deadlocked or Congress rejects its recommendations, then automatic spending cuts of at least $1.2 trillion will go into effect.

•         Requires that the House and the Senate vote on a Balanced Budget Amendment to the Constitution, although its passage is not guaranteed.

The Bad: Even with the 11^th hour deal one of the three major rating agencies - S&P- still issued the first ever downgrade to the United States, going from AAA to AA+ with negative watch.  It has been noted that the downgrade was based in part on the ongoing uncertainty regarding Washington’s ability to solve the United States longer term debt problem4.  After the downgrade, we saw well known investors (Gross vs. Buffet) disagree about the correctness of the downgrade; other major rating agencies reaffirm their ratings but indicated things could change5; and substantial pressure in the global markets.  Our view was that the downgrade was a less than surprising event given (our analyses indicating) that any non-comprehensive agreement could potentially lead to default or downgrade. This deal felt more akin to a game of kick- the-can which gave Washington additional time to come up with a more definitive plan. Admittedly the agreement did stave off default potential but it seemed to us more smoke and mirrors rather than a substantial solution.  Looking ahead the bipartisan committee will again debate the issues of tax increases versus spending cuts.  In our view this committee is fundamentally designed to fail, given the extremist views creeping in from both sides of the aisle. 

The ultimate success or failure is an unknown but what is clear to many like us is that the only way to put the US economy back on the right path is through a combination of spending and tax measures.

The Ugly: Throughout much of the year the most fitting word to describe the United States economic environment is ugly.  Certainly there have been positive signs in the business and financial sectors which have seen increases in both orders and profitability, BUT these positives have been more than offset by dour news in total economic output (i.e. GDP) and employment. 

In the near term we believe that more ugliness can rear its head in any number of different ways, e.g. continued sell off in the markets, sudden and significant rise in interest rates, etc; where ever the ugliness may come from it is predicated on our belief that Washington is still slumbering, possibly unaware or unwilling to do what is ultimately required.

A Hollywood Ending? During the final portion of the classic western there were numerous gun battles to decide who will ultimately get the gold.  In the final scene, after one last twist, both men shared the gold equally but not without some remaining animosity.

When all is said and done will Washington have a similar Hollywood ending? Only time will tell…