Tug of War, Greece & Portugal

This newsletter has 3 segments: the economic update from Vanguard, the tug of war on Wall Street between fear over European budget deficits versus an improving economic outlook, and information on the measures that Greece and Portugal are taking to address their debt burden. It is important to watch the actions of the European countries as this gives us a glimpse of what will happen to us as our debt burden continues to grow.

Vanguard Information:

The United States continued to show signs of recovery this week as retail sales, industrial production, and business inventories all increased. Although the good news was somewhat dampened by a widening trade deficit in March, many economists believe the continued increase in both U.S. exports and imports is another signal of an economy that is beginning to strengthen. For the week ended May 14, the S&P 500 Index rose 2.2% to about 1,136 (for a year-to-date total return—including price change plus dividends—of about 2.6%). The yield of the 10-year U.S. Treasury note fell 1 basis point to 3.44% (for a year-to-date decrease of 41 basis points).

Tug of War:

The tug of war between fear with European debt versus the improving economic picture continued into the 3rd week. Early in the week the focus was on the improving USA and global economy, fear was gone, and the stock market rejoiced. Late in the week fear reigned supreme and people forgot about an improving economy and the stock market cried. It is like people on one side of the rope gave up for a few days followed by the people on the other side giving up.

The good news about this is that Eurpoean nations are addressing their debt issue and it shows us likely events that will occur in our nation as our debt to GDP ratio is now at about 90% and growing. This means that eventually the improving global economy should be the winning side in the tug of war. The question is how long will this game continue, giving us plenty of volatility.

Every cloud has a silver lining and this fear of debt does benefit us consumers in a few ways. First, long term interest rates are dropping which lowers mortgage rates low as well as giving us very nice gains in our bond mutual funds. Second, commodity prices except gold, are dropping which will lower the price of oil, gasoline, copper, etc. Third, it is cheaper to travel to Europe as the euro weakens versus the US dollar.

Greece and Portugal Debt Reduction:

Greece and Portugal have started their spending austerity programs to balance the budget. Greece chose a path that reduces pensions and raises taxes. Portugal chose a path that reduces spending and raises taxes. Portugal, reduced government salaries by 5% and froze them for next year as well as adding a Value Added Tax, VAT, and eliminating the tax credit for having a child. Greece has a higher debt to GDP ratio than Portugal and kept a focus on long term pension obligations. Portugal being in better financial condition kept a focus on shorter term obligations. A Value Added Tax is a nice way to say a higher sales tax.

What does this mean for us? Expect a progression approach where we act like Portugal initially followed by acting like Greece. This means expect subtle tax increases like a VAT and elimination of the child tax credit that was started under the Bush 2 administration. If you listen to the experts in the news about or budget deficit they state that the biggest budget problem is entitlements such as Social Security and Medicare, the same solution adopted by Greece.