By Ron C. Dugan, CFA, Vice President and Global Investment Strategist
What is the significance of the U.S. raising the Federal Debt Limit (“the Debt Ceiling”)?
The problem is that this is more of a political issue than an economic issue. The only rational action to take is to raise the Debt Ceiling so as to avoid even the appearance of a technical default on US government debt. No one willingly wishes to increase the Federal Debt Limit but the possible downstream ramifications from a technical default are too uncertain to consider.
Nevertheless, politicians are taking this opportunity to posture for the next election by demonstrating how they are opposed to increasing the US Government debt levels beyond the current $14.3 trillion debt limit. Several legislators are using this issue as a means to negotiate spending cuts in exchange for their vote to increase the Debt Ceiling.
The recent decline in US Treasury yields indicates that investors are currently shrugging off the possibility that the US could default as early as August if Congress does not agree to raise the country’s borrowing limit. They are instead paying much more attention to evidence of deteriorating economic growth and an anemic housing market before the end of the Federal Reserve’s quantitative easing policy (“QE2”) this month. The recent news on disappointing job growth and an uptick in unemployment are viewed as much more serious issues today.
Most observers expect that the Debt Ceiling will be raised just before the final deadline hour and that the US government debt markets and Washington will continue to operate and function as they do today.
What impact will inflation have on equity and fixed-income investments?
Inflation affects all aspects of the economy, from consumer spending, business investment, and employment rates, to government programs, tax policies, and interest rates. Understanding inflation is crucial to investing because inflation can reduce the value of investment returns.
The impact of inflation on your portfolio depends on the type of investments you hold. If you invest only in stocks, inflation is less troublesome. Over the long run, a company's revenue and earnings should increase at the same pace as inflation, thereby providing some reduction of inflation risk. However, there may be periods where a combination of a bad economy with an increase in costs is bad for stocks. The main problem with stocks and inflation is that a company may look like it is prospering, when really inflation is the single reason behind the growth.
If you have a substantial portion of your portfolio in fixed income investments, inflation will have a more meaningful impact. Inflation erodes your purchasing power and investors on fixed incomes suffer when their nest egg buys less each passing year. This is why many financial advisers caution retirees to keep some percentage of their assets in the stock market as a partial hedge against inflation.
Generally, higher inflation or the expectation of higher inflation, in isolation, may lead to higher interest rates (lower bond values) and weaker stock prices in the short-term. When consumers expect things to cost more in the future, they often put less value on their financial assets.
Inflation is one of the financial facts of life. You cannot control it, and you do not know what it will be in the future. However, you should be aware of inflation trends, factor a realistic expectation into your thinking, and take steps to protect your finances just in case the inflation rate rises. Inflation rates have been low recently, but there are no assurances the low rates will continue.
All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.