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December 5, 2011

In the post-recession environment, many sovereign nations are running annual budget deficits.  By spending more revenue than they collect, they are increasing their debt loads, and require the capital markets to fund their spending habits.  Needless to say, running long term annual deficits is not sustainable, and eventually demands a correction.  Otherwise, a given sovereign nation could experience a substantial increase in borrowing costs, or worse, a possible default.  Many economists argue that deficit spending is necessary to help bring a struggling economy out of a recession, but a long term, sustainable strategy should be enacted.  Despite a large deficit, the failure of the SuperCommittee, a ratings downgrade in August 2011 by Standard and Poor’s, and negative ratings outlooks from  Moody’s, Standard and Poor’s, and Fitch, the U.S. continues to experience near record low borrowing costs.

The SuperCommittee was created in August 2011 through the Budget Control Act, to help resolve the budget woes.  They were incentivized to come to an agreement by Novermber 23rd, or face the threat of $1.2 trillion in automatic spending cuts, which the military would bear the brunt of.  To the surprise of very few, the SuperCommittee failed to agree on much, and the automatic spending cuts are scheduled to be triggered beginning in 2013.

To understand the failure of the SuperCommittee, it is critical to understand the revenue and expenses of the U.S. Government.  From a revenue perspective, raising taxes is not popular, and voters tend to prefer politicians who discuss reducing taxes.  As a result, tax revenues are the lowest they have been as a percentage of GDP in approximately 60 years.  Expenses have moved in the opposite direction, and politicians who threaten to reduce expenses which benefit their constituents are generally not very well received.  The allocation of the $3.7 billion 2011 budget is as follows: 23.8% to healthcare including Medicare/Medicaid, 20% to national defense, 20% to social security, 15.4% to welfare, 6.8% to servicing debt, leaving approximately 14% of the budget for the remaining obligations of the federal government including, but not limited to, education, transportation, veterans affairs, science, energy, international affairs, commerce, agriculture, and administration.  The U.S. deficit is projected to be approximately 30% of revenues, which makes balancing the budget somewhat challenging.

As a result of the unsuccessful budget debates, the major ratings agencies have placed negative outlooks on U.S. debt.  When evaluating sovereign nations, since most are running budget deficits, it is critical to evaluate the issuer’s ability to refinance their debt, since they are unable to satisfy their current obligations with their current revenues.  Standard and Poor’s kicked off with a ratings downgrade to ‘AA+’ in August 2011 where they cited the debt loads as troubling, but inline with other ‘AAA’ rated sovereign nations.  However, they stated the political process in the U.S. was not consistent with other ‘AAA’ rated nations, referencing politicians’ inability to negotiate, and certain politicians threatening to not pay bills they already agreed to pay.  Such action would constitute a selective default.  Since then, both Moody’s and Standard and Poor’s affirmed their negative outlook on November 21st, though stated the $1.2 trillion in automatic spending cuts would be sufficient to maintain the ‘AAA’ rating.  Fitch followed suit on November 28th with a negative outlook, citing a lack of faith in the government’s ability to reduce expenses, and increase revenues in a timely manner.

Despite the state of the U.S. budget, and negative ratings outlooks, the U.S. continues to experience record low interest rates.  At the surface this may defy logic, but it reflects two key characteristics of U.S. debt: safety and liquidity.  While there may be safer credits available, they may not provide the liquidity available in U.S. Treasuries.  As a result, it is relatively easy for the U.S. to refinance its ever increasing debt, particularly when compared to some of its European counterparts.  In addition, treasury prices have historically reflected inflationary expectations.  Based on historical averages, it seems inevitable that Treasury rates will increase, but seemingly every time a headline spooks investors, they flock en masse to Treasuries, and rates decline.  Treasuries reflect a good opportunity for investors exclusively seeking safety and liquidity, but for the long term investor, the yields may struggle to keep up with inflation.  There is an abundance of opportunity in the fixed income marketplace, and we encourage you to discuss your portfolio with your Alamo Capital Representative to ensure it aligns with your objectives.

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This report is prepared for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or service.  Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy. Any comments, statements and/or recommendations made herein are subject to change without notice, and may not necessarily reflect those of Alamo Capital.  Alamo Capital has no affiliation with any political party. Investing involves risk. Consult with a Financial Professional for additional information to determine the suitability of this or any other financial product or issue as it relates to your particular situation.