Although the media was transfixed with the debate, the debt ceiling issue and the risk of the U.S. defaulting on its debt was never much of a concern for investment markets over the last few weeks. If it had been, we would have likely seen a major sell off in Treasuries with yields spiking higher. Instead, the Treasury market has been in rally mode, gaining +3.2% for the month of July including +1.3% last week in the final tense days leading up to the ultimate resolution.
So what explains why stocks have been struggling over the past few weeks? Certainly, the uncertainty resulting from the debt ceiling debate has not helped stocks, but this has been an ancillary reason at best. Instead, three factors have had stocks under increasing pressure, and these challenges will still remain once the debt ceiling debate goes away. They are the following:
1. The Economy is Slowing
A growing economy is the primary fuel to sustain higher stock prices. But nearly all signals suggest that the economy is weakening with each passing month and recession risks are on the rise.
2. Fiscal and Monetary Stimulus is Spent
A primary driver of the market rally over the last two years has been the massive support from government spending and Fed stimulus programs like near zero interest rates, QE1 and QE2. But a key takeaway from the debt ceiling debate is that any additional government spending to boost the economy is highly unlikely going forward. And the Fed’s QE2 program came to an end on June 30 with no talk of QE3 coming any time soon.
3. The European Crisis Keeps Getting Worse
Euro Zone leaders announced a major rescue package on July 21 that was supposed to provide the continent six months to a year to regroup and stabilize. But problems are already starting to resurface after only a week. And although the issue is in Europe, it has the potential for major negative spillover effects on the global banking system including the U.S. Looking ahead, Spain and Italy are the countries that are likely to garner the most media attention for their problems in the coming weeks.
So while we’re likely to see stocks rally strongly over the next few days in celebration of the debt ceiling debate finally ending, they’re likely to soon falter and begin struggling once again primarily for these three reasons.
Fortunately, a variety of asset classes perform very well in such economic environments like we have today, and portfolios have been positioned to benefit. These include bonds such as U.S. Treasuries and precious metals such as Gold, both of which are considered safe haven investments during times of uncertainty. Both of these categories have been performing very well over the past several weeks and portfolios have been meaningfully weighted to both Treasuries and Gold to capitalize. Treasuries are up +6.8% for 2011 year to date including a +3.2% advance in July, while Gold is up +14.1% for the year including an +8.4% gain this past month.
In the coming days, the debt ceiling relief rally should provide a good trading opportunity to lock in gains on selected stock positions. And the accompanying safe haven sell off may also provide the potential to add to existing bond and precious metals positions on the dip, as these are the categories that are likely to continue to perform well in the coming months as markets work to navigate through ongoing economic challenges.
I will continue to keep you posted as events unfold.