Category: Economic Insight

Economic Insight

Still No Resolution on the Debt Ceiling

A month and a half has passed since the U.S. hit the debt ceiling in May and an agreement still has not be reached to raise it. There is an obvious concern over what would happen if a debt ceiling increase deal is not completed by August, and the reverberating impact it would have on the global financial markets. First, the risk is currently that rating agencies will downgrade US debt to “selective default” if the U.S. misses a debt payment in August. That means US debt maturing on August 4 would be rated “D.” This could also lead to a possible downgrade of overall US debt, that would be felt throughout the financial system, which is the fear the news is reporting.

It is important to step back out of the media spotlight and consider a couple more important points. The first, and usually the most timely barometer, is how the global market has reacted to the news. Over the past five days the market has steadily increased and is up 5.5% for its best week in two years. Also, the current yield on the 10 year Treasury was near its lowest point of the year last week, and is still well below where it began the year. If there was grave concern over the future of U.S. Government debt, the yield would have climbed significantly higher by now. This has all happened while the debt ceiling limit is fast approaching. Another point is that the US Treasury also has additional tools at its disposal to take extraordinary measures to forestall a default on US debt, without the debt ceiling being raised by congress. Although these tools do not come without significant long term side effects.

Judging from the consensus opinion of analysts around the globe, the market has reviewed the problem, analyzed the potential impact, and concluded that the probability of the US not reaching an agreement eventually is low enough not to offset other positive economic news (manufacturing growth, Greece passing austerity measures, and other economic figures that were better than expected). Although the current politicizing of the debt ceiling is much akin to playing chicken with a racecar, it is still important to review what the collective voice of the market is telling us. The sky is not falling.

We continue to remain confident in U.S. Government bonds and we do not recommend making any changes in your portfolios at this time.

How Do Deficits and Debt Interact With Equity Markets?

With government spending at record levels worldwide many political leaders, economists and analysts are cautioning that global markets and economies could be hamstrung by the rising tide of government debt. Many investors are now concerned as they believe a government’s fiscal policy is closely tied to the country’s economic performance and market growth.

The following chart shows the projected level of debt for Organization of Economic Co-operation and Development (OECD) countries for 2010.1 More than half the OECD member countries are expected to have debt-to-GDP levels above 70% with the US, UK and Canada projected to have debt levels matching over 80% of their countries’ economic output.
Government attempts to spend these economies out of recession may explain such historically high levels of borrowing. However, overriding trends like the increasingly older world population, the increasing healthcare costs that come with it and growing public pensions are adding to the challenges of these countries’ fiscal policies.

Investors are fearful of the results of large scale government spending across the globe. So how are economic growth and financial markets returns affected by governments’ large debt position? The facts might surprise you. While increasing government debt levels make it tougher for economic growth, a country’s budget shortfall and debt levels appear to have a minimal impact on capital market performance.

The following drills down deeper into these issues by examining several of the common questions about sovereign debt:

Do growing deficits drive up interest rates?
Yes. As a country borrows more and more it must offer investors a higher interest rate to compensate the investors for the risk they are taking investing in a more levered borrower. With increasing debt levels the risk of default increases and worries over inflation combine to augment investor demand for still higher interest rates. Meanwhile, the money lent to governments eliminates the chance for these funds to be used to drive growth in the private sector.

In line with this premise, an analysis shows that future deficit expectations are reflected in current interest rates,2 but the debt and deficit level that the government currently has does not forecast future interest rates or fixed income performance.3 While, long-term interest rates increase when the market expects future deficits to rise, current interest rates and bond prices already include information about existing government spending and markets quickly assimilate any new data.

Do greater deficits hinder economic growth?
The answer to this varies based on the country’s indebtedness. Looking at World Bank data from 1991 to 2008, we compared current deficit to future GDP growth in sixty-seven countries and found an increasing inter-relatedness between debt, deficits and economic growth. Countries that continue to maintain high deficits and heavy debt are more likely to achieve weaker economic growth over the following three years. However, there are many factors that determine a country’s’ economic direction and deficits explain just a fraction of the variation in future GDP growth. While a heavy debt burden and running a deficit can impede economic expansion it does automatically result in slower growth.

There is some evidence that investors should be concerned about high government borrowing and spending, but their effect on investment performance is not clear.

Are equity returns hurt by light economic growth?
We can look at this relationship by comparing a country’s GDP growth to its equity market performance in succeeding years. We looked at all developed countries in the MSCI universe and separated every year into either high-growth or low-growth “portfolios” based on the country’s real GDP growth. The results showed that the annual returns of stock markets in high growth countries were not statically different than the returns in low growth countries and low growth countries actually had somewhat higher average returns.

The following chart displays shows the growth of $1 if it was invested in a high or low GDP growth country portfolios from 1971 to 2008. The low GDP growth portfolio would have resulted in having more wealth for the time frame. The chart lists the average annual return and real GDP growth for both sets.


If the same methodology is applied to MSCI emerging market countries an even larger discrepancy is found. The high growth country portfolio returned an average of 19.77% with positive GDP growth and the low growth portfolio returned 24.62% with negative GDP growth. The data covers a shorter period from 2001 to 2008, however.

Other studies have found a similar weak relationship between a country’s economic growth and its stock market performance.4 There are several issues that could lead to this divergence. With increasing globalization, a multinational company’s stock price could reflect its performance abroad, which might differ from its home market. In addition, the benefits of a country’s’ economic growth does not get perfectly passed to public companies. There are also workers private businesses and investment.

Lastly, it is risk and expected future cash flows that determine a stock’s expected return and, not economic growth. It has been shown that this relationship also exists for a country’s stock market.5 As with value and growth stocks, stock markets with a low aggregate price relative to aggregate earnings or book value have higher expected returns. Whereas markets with a high relative price have lower expected returns. Thus, by investing in markets that are expected to have high GDP growth, an investor should not anticipate higher performance.

Can currency depreciation result from fiscal deficits?
It is widely held that as governments run up deficits and increase their borrowing from global sources, their currency will fall. Investors, fearing inflation and potential default, seek to invest elsewhere. While current events in the U.S. might support this relationship, the long term picture shows a different story. In the 1970s and 1980s, the U.S. government raised deficit spending and yet the dollar strengthened.6, This evidence dovetails with academic studies that maintain exchange rates move indiscriminately and currently there are no financial models that can consistently project currency returns.7

With increasing government deficits, which are likely to exist for some time, there are economists claiming that developed countries’ markets will face lower market returns. Larger deficits and debt can possibly affect a country’s interest rates and economic growth, but their influences on market returns are not clear. Looking at historical evidence there is little support that short term currency depreciation and future bond or equity returns are predicted by current deficits.

Investors should assume that all public information regarding government spending and debt levels, economic growth, risk and other future expectations are reflected in current stock and bond prices.

1. The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. It defines itself as a forum of countries committed to democracy and the market economy.

2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.

6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.

7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).

Raffa Wealth Management is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered personal investment advice.

Rates Can Only Go Higher

Weston J. Wellington, Vice President, Dimensional Fund Advisors

It seemed so obvious. With the economy slowly recovering last year from the worst recession in decades and the federal government seeking to tap the credit markets for over $2 trillion to fund an ambitious spending program, both laymen and experts alike seemed to agree that interest rates had nowhere to go but up. The yield on the ten-year U.S. Treasury note as of June 30, 2009 was 3.52%, down from 5.25% in June 2007 but well above the 2.09% level registered amidst the depths of the credit crisis the previous December. With retail sales and housing activity showing signs of gradual improvement, the only question appeared to be how much higher interest rates would go.

Among fifty economic forecasters surveyed by the Wall Street Journal in June 2009, forty-three expected the ten-year U.S. Treasury note yield to move higher over the year ahead, with an average estimate of 4.13%. Seven expected a rate of 5.00% or higher while only two predicted rates to fall below 3.00%. The result? The ten-year Treasury yield slumped to 2.95% on June 30, 2010 and rates on 30-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971. How many of us would have expected this during a period when gold prices soared over 33% to a record high?

Some observers may be tempted to poke fun at these hapless “experts”, implying they are incompetent or poorly informed. This interpretation is flawed since it suggests that a better team of experts would achieve a more accurate result. A more useful explanation is that even the most talented analysts are unlikely to make reliable predictions and the poor showing by this particular group is simply what we would expect to see, just as often as not, if markets are working freely and fairly. Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation and these expectations can change quickly in response to new information. However tempting it may be to believe that we can predict the future better than other market participants through careful study, the results of the Wall Street Journal survey as well as numerous other efforts suggest this confidence is misplaced.

What is the message for investors? Predicting interest rates and bond prices is no easier than predicting stock prices, and making decisions based on what appear to be certain outcomes at the time can often prove costly. Many investors reconfigured their portfolios in anticipation of higher interest rates and have penalized their results while they are waiting.

Instead of seeking to predict the unpredictable, investors are much more likely to enhance their results by focusing on the elements they can control – risk exposure, diversification and minimizing costs and taxes.

Yahoo! Finance accessed July 7, 2010. Wall Street Journal Forecasting Survey accessed July 7, 2010. Prabha Natarajan and Matt Phillips. “Stocks Drop; So Do Mortgage Rates” Wall Street Journal, June 25, 2010.

Mark Gongloff. “Two Treasury Forecasts: a Grand Canyon-Sized Gap” Wall Street Journal, April 10, 2010.

Tom Petruno. “Gold Hits Record as Investors Seek Haven” Los Angeles Times, June 9, 2010.

Weston Wellington and Dimensional Fund Advisors are not affiliated in any way with Raffa Wealth Management.


Raffa Wealth Management is an independent investment advisor providing nonprofit organizations, high net-worth investors, and qualified retirement plans with a full range of investment consulting services.  We were established to fill the need for transparency, clarity, and vision in the professional management of investment assets.   Visit us at

The Lost Decade?

As January 1st passes, there have been stories all over the financial press
about the “Lost Decade” for US Equities.  These headlines
are certainly eye-catching and feed on investor’s recent memories of
2008 where the S&P 500 lost -37% in 12 months, and another -11% through
the first quarter.  These articles are spot on when it comes to the
S&P 500, a large cap US equity index, which had an annualized loss of
almost -1% per year over the past decade.  The Russell
3000 index, which incorporates large, mid, and small cap stocks also suffered
an annualized loss of -0.20% during the past ten years.  In
order to understand the differences between these two indices, we need to
explore what makes up the Russell 3000.

Nine US Equity Styles

The Russell 3000 index can be broken into nine separate components.  The
subparts are split up by the size of the companies issuing the stocks (Large,
Mid, and Small), as well as the relative strength/value of each stock (Value,
Blend, and Growth).  Doing so allows us to see a very different story:

This chart illustrates that across all market caps, Value stocks significantly
outperformed their Blend and Growth counterparts.  Investors who
held Small Value stocks should have seen them return +8.27% per
year through the past decade.  The chart also illustrates that
Small and Mid Cap stocks outperformed their large counterparts in all
categories over the past decade.

RWM’s investment philosophy in the US Equity market is to emphasize
Small and Value stocks, while owning a percentage of each category.  Over
this timeframe, that strategy has added value compared to a more market
neutral index, such as the Russell 3000, due to its allocation to Small
and Value stocks. 

It’s also important to understand that while we believe Small
and Value stocks will offer long term excess returns over a more market
neutral strategy, over shorter time periods, that emphasis may underperform
the market.  For instance, Small Value stocks gained +20.6% in
2009 compared to the Russell 3000’s gain of +28.3%,
however even this lower relative performance didn’t stop Small
Value stocks from beating the Russell 3000 by nearly +8.5% annually
in the last decade.  RWM’s focus in the US Equity market
is to have exposure to all sectors, so that we will experience the
market return, while emphasizing Small and Value stocks which have
demonstrated added value over longer periods of time.

International Equity Exposure

We also still believe that an allocation to Developed International
Markets and Emerging International Markets play a role in diversified
portfolios.  As we saw in 2008, US and International markets
can move in the same direction, as International stocks lost over -45% and
Emerging Market stocks fell -53%.  However, these
markets snapped back even stronger in 2009, gaining +31.8% and +78.5% respectively.  The
ten year annualized returns also exceed that of the broad US Equity
markets, and we can see that Value stocks in the Developed International
Markets exceeded the returns of the market neutral index:

Fixed Income Allocation

Finally, it’s important to discuss the importance of bonds within
a diversified portfolio.  Bonds serve as a counter weight within
your portfolio, adding stability during times of economic stress, while
providing real returns to investors.  Like the trend we discussed
in the US Equity markets, bonds can, at times, actually lose value.  We
expect that those losses, however, will be significantly smaller than
those of the stocks, and will likely occur at a point when stocks are
in favor and are gaining value.  As the chart below illustrates,
adding 10% of a broad market bond fund to the Russell 3000 index over
the last ten years would have changed the portfolio’s return
from an annualized loss to a gain.

The Next Decade

While many analysts are trying to predict at what level the Dow will
close on December 31st of this year, we believe that the lessons from
the last decade and dating all the way back to the 1920s and 1930s
are still very relevant to investors:

  • Eliminate unnecessary risk from your portfolio, including individual
    company risk and sector risk
  • Have broad and diversified exposure among
    your holdingsSmall and Value stocks will likely add value over time
  • Having
    exposure to Developed and Emerging International markets will likely
    add value over time
  • Pick an appropriate allocation to stocks and bonds
    that will allow you to stay the course in turbulent markets
  • Do not
    allow short term market disruptions to disrupt your long term plans,
    as this will likely result in selling low and buying high
  • Execute
    your investment strategy as efficiently as possible


Raffa Wealth Management is an independent investment advisor providing
nonprofit organizations and high net worth individuals with a full range
of investment consulting services.  We were established to fill
the need for transparency, clarity, and vision in the professional management
of investment assets.   Visit us at

Important Disclosure

Past performance is not a guarantee of future results and there is
always a risk that an investor may lose money.  Information contained
has been gathered from sources we believe to be reliable, but we do
not guarantee the accuracy or completeness of such information. Indices
are not available for direct investment and performance does not reflect
expenses of an actual portfolio. Such expense would reduce the returns
illustrated.  Returns are shown gross RWM’s advisory fee.
The incurrence or inclusion of an advisory fee will have the effect
decreasing performance results.  For example an advisory fee of
1% compounded over a ten year period would reduce a 10% return to an
8.9% annual return.   RWM’s form ADV is available upon
request.  The form ADV is the RIA disclosure document that outlines
material arrangements and business practices.

Is the market rebound justified?

The short answer is yes. The rebound is ‘justified’ because of the way that the market prices securities – not because I know any more than you about the future direction of the economy in the short term. Let me explain…

“The financial market works as a conduit for demand and supply of (primarily) long-term debt and equity capital.”1 In other words, stock and bond prices are determined when the demand from those seeking capital meets the supply that we as savers are willing to invest. You surely remember the fascinating line charts in economics class identifying the low price of a widget at the intersection of healthy widget supply and slumping widget demand. Stock and bond prices work the same way – and I’m delighted to inform you that it’s this simple.

The foundation of our capital market started to crack in September of 2008 and what ensued was a flight of investor demand from all things risky. Stock and corporate bond prices plummeted to a level not seen since early 1997. Treasury bond prices soared. The rebound we’ve enjoyed since March has been the simple, direct response of increased investor demand brought on by the confidence that our capital market system is no longer on the brink of collapse.

So when some say that the market has gotten it wrong – it’s being suggesting that either the supply side or the demand side is incorrectly forecasting future economic growth today. One or both sides will surely get it wrong from time to time but the bottom line is that supply and demand (the market) has set the price today and that’s the best indication of the level of growth to come. News will break tomorrow that alters both sides of the equation and prices will change – quickly. Until then, the price is right!

Clearly the question is posed with the hope that I, or someone, will foresee the next downturn and help you avoid suffering another setback. I have no doubt that fear will once again shake investor confidence and drive prices lower. The challenge is that it is impossible to know when this may occur. It’s impossible because it depends on knowledge of events that have not yet occurred.

The following quotes demonstrate the challenge with trying to predict future market prices:

“Without a sustained improvement in the credit market — the seat of the crisis—it seems irrational to expect a durable move higher in equities.”
—Richard Barley, “Bond Markets Don’t Buy the Rally,” Wall Street Journal, March 26, 2009.

“New research shows corporate bonds have been far better at predicting where the economy is headed than anyone thought. Unfortunately, that suggests the economy is going to get much worse.”
—Justin Lahart, “A Warning from the Bond Market,” Wall Street Journal, April 9, 2009.

“The March stock market rally that fuelled hopes of a broader economic recovery was deceptive because ‘real money’ investors remained on the sidelines.”
—Anuj Gangahr and Chrystia Freeland, “Head of NYSE Cautious over Rally in March,” Financial Times, April 16, 2009.

“April saw the lowest level of insider buying ever recorded by research group TrimTabs, with insider selling fourteen times as high. Likewise, companies sold 64% more shares than they bought in April.”
— Spencer Jakab, “Beware the Seductive Appeal of the Suckers Rally,” Financial Times, May 9, 2009.

“Markets need volume to sustain bull runs, but unfortunately this run does not have it. In fact, trading volume on the New York Stock Exchange has been trending lower all month.”
— Michael Kahn, “This Bear Should Stay Well Fed,” Barron’s, May 20, 2009.

“We are still a long way from a viable, solvent banking system that intermediates credit independently.”
—George Magnus, “Reasons Why Bear Market Rally Will Stall and Reverse,” Financial Times, May 21, 2009.

Since March 9, 2009 the S&P 500 stock index has rebound by over 60%3 – indicating the potential cost of relying on market predictions.

I encourage you to avoid getting caught up in identifying the degree to which the market is ‘right’, or ‘justified’, in how it is pricing securities. These are interesting discussions (mildly) but not at all practical in building and sustaining long term wealth.

The important question is how we should invest in an environment in which the future is uncertain. The answer is by eliminating unnecessary risks and expenses and balancing competing priorities based on cash flow requirements and time frames. In other words, focus on the things that you can control. Successful long term investors don’t seek to avoid setbacks – they invest in a manner that allows them to endure setbacks and enjoy the recoveries that inevitably follow