Greek Bailout- Last week euro-zone leaders agreed on a second rescue package for Greece that provides the country with much needed cash while placing some of the bailout’s burden on Greece’s private creditors. Through extensions of debt maturities and reductions in interest rates, the plan seeks to reduce the debt servicing burden of the country and allow it more time to work its way out of the hole it dug for itself. The EU will take on more responsibility for Greece’s debts and Greece consequently won’t have to go to the capital markets for funding for some years. Essentially the plan is a bond exchange program that converts all of Greece’s bond obligations for the next several years into loans from the European Financial Stability Facility (EFSF). Holders of Greek bonds to the tune of 135 billion euro’s will have to accept new securities that give them less than originally promised. Maturities on these new loans will be extended to between 15 and 30 years with a grace period of 10 years and the interest rate paid will be reduced. Also, the EFSF will have the ability to enter the secondary market and buy bonds in order to stabilize conditions. The plan effectively frees Greece from having to seek funding in the bond market until 2016 or 2017, if all goes according to plan. The EFSF plans to implement similar terms for Ireland and Portugal. The plan also allows for faster methods of disbursing credit lines to Italy and Spain and for bank recapitalizations, if necessary.  

The structure of the deal has several moving parts, but essentially a holder of short-term Greek debt will have the option of keeping the face value of the bond and extending the maturity or taking a 20% reduction to the face value of the bond and extending the maturity, but earning a higher interest rate. For example, the holder of a Greek bond maturing in 2012 could do any of the following: extend the maturity to 30 years at a 4.5% interest rate; take a 20% reduction in the value of the bond and extend the maturity to 15 years at a 5.9% interest rate; or take a 20% reduction in value and extend the maturity to 30 years at a 6.42% interest rate. The principal of the new 30 year bonds will be collateralized by 30 year AAA rated zero coupon bonds that Greece will purchase with bailout funds. At maturity, these bonds will provide the proceeds to repay the investor. In the meantime, Greece makes interest payments to the investor on the new securities as well as to the bailout fund on the money used to purchase the zero coupon bonds. The new 15 year bonds will be partially backed by escrowed funds.

This is a liquidity solution not a solvency solution. It relieves the immediate pressure, transfers some responsibility to the eurocrats, and gives Greece some breathing room to tackle its austerity measures and privatization targets. But those measures need to be successful and the country’s balance sheet and economy strengthened, or there will be another debt crisis in a few years. What it doesn’t do is significantly reduce the amount of debt in the system. The bond exchange program will cut about 26 billion euro from Greece’s overall 350 billion euro debt load. In the end Europe now has a lot more skin in the game and would be reluctant to allow the efforts to fail.

Financial Markets- The Standard & Poor’s 500 gained 2.2% last week and the MSCI EAFE index of international markets increased 3.4% in U.S. dollar terms. The dollar fell versus the Euro, the Pound, and the Yen. The ten year treasury yield increased to 2.96% while the two year yield rose to 0.39%. Gold rose 1.0% and oil increased 1.4%.

Other Economic News Last Week

-Housing starts jumped nearly 15% in June from May’s level.

-The Philadelphia Fed’s General Activity Index was stronger than expected.

-The Conference Board’s index of Leading Economic indicators advanced in June.

The following is not intended to reflect any specific investment portfolio managed by WheelerFrost Associates, Inc. or to provide investment advice. Investment recommendations made by WheelerFrost Associates, Inc. are given only on a client  by client basis in conjunction with a specific investment plan.

Current Outlook

-          We are maintaining a “neutral” view of stocks with a cautious outlook, given the uncertainties arising from the budget standoff in the U.S. and the sovereign debt crisis in Europe.

-          Developed countries appear attractive versus the U.S. on valuation criteria.

-          Emerging countries appear attractive versus the U.S. on growth criteria.

-          Favor commodity exposure as a hedge against commodity induced inflationary pressures.

-          Corporate and mortgage-backed bonds are favored over treasuries.

-          Municipal bonds have rallied substantially from panic induced levels earlier in the year but remain relatively attractive compared to treasuries.

-          Favor State General Obligation municipal debt as well as essential services issues.

Risks

-          Higher oil prices due to Middle East turmoil and emerging country demand.

-          Potentially over-stimulative Fed policies and rising commodity prices are inflationary threats.

-          Debt levels and budget deficits in developed countries pose threats to sovereign debt.

-          Credit conditions remain challenging for individuals and small business.

-          Inflation concerns in emerging countries are forcing monetary tightening that could lead to slower global growth.

-          Renewed housing weakness threatens to weaken an already weak recovery.

This review is compiled from various research sources and nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. While WheelerFrost Associates, Inc. has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein. Information provided reflects WheelerFrost Associates, Inc. views as of a particular time. Such views are subject to change at any point and WheelerFrost Associates Inc. shall not be obligated to provide notice of any change.

The Debt Ceiling and Budget- Last week both Moody’s and Standard and Poor’s threatened to lower the credit rating on U.S. debt if meaningful progress isn’t made on the budget and debt ceiling issues. Moody’s cited “the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on U.S. Treasury obligations.” Without getting on too big of a soap box, let me point out that since World War II revenue to the government has averaged about 18% of Gross Domestic Product (GDP) per year. However, spending has averaged 20% of GDP per year. Thus, on average, we have had a budget deficit each year since the 1940’s that averages about 2% of GDP. Individual years vary, of course, but balanced budgets have been extremely rare. For example, during recessionary years revenues tend to decline while expenditures increase. In expansions revenues rise rapidly, though expenditures rarely decline. Another characteristic is that revenues are more volatile than expenditures because of the non-discretionary nature of a large chunk of government spending. During recessions revenues often decline dramatically, over 15% most recently, while expenditures have not declined more than 3% over a twelve month period since the mid 1960’s. Over the twelve months ending in June, federal receipts have grown 8.8% while outlays have increased 3.3%. This result was achieved during a period of disappointing, though positive, economic expansion. If the economy was more robust revenues would have increased more dramatically. Each year we borrow to finance the deficit and that borrowing then gets added to the accumulated debt of the country. The concept of a debt ceiling came into being during World War I in order to limit debt build-up during the war. It has been argued by many observers that a mandatory debt limit doesn’t make much sense, and in fact many countries don’t have one. Normally, the debt ceiling is raised without much controversy, but on occasion there has been political battle over the issue. Also, the battle lines shift. For example, as a Senator, President Obama voted against raising the debt ceiling in 2006 while many in the current republican leadership voted in favor.

The current debt ceiling “crisis” is really a combination of the need to raise the statutory debt limit in order for the government to continue to pay its bills and the more fundamental and philosophical battle over the budget and its long-term implications. The debt ceiling “crisis” could be dealt with temporarily by simply raising the ceiling. However, chronic budget deficits will ensure that it will become an issue again in the future. The budget problem is long-term in nature and is centered on non-discretionary and entitlement spending. According to Raymond James & Associates, if congress left Medicare, Social Security, and defense spending untouched and cut all other expenditures to zero, we would still have a budget deficit this year. As the baby boom generation retires, this problem will only be exacerbated, especially spending on Medcare.

There is a misconception by some that if the debt ceiling is not raised the government would be prevented from spending more than it receives. But that is not how the budget process works. To a large degree, the money has already been allocated. If the ceiling is not raised the government would likely continue to make interest payments on debt in order not to default. Other payments, such as Medicare, Social Security, and veterans’ benefits, would likely be delayed, but eventually paid. Contractors may not be paid in a timely fashion and government workers likely sent home, though eventually paid whether they worked or not. The current stalemate with the debt ceiling used as a bargaining tool risks the credit rating of the country and that seems a risk not worth taking.     

Financial Markets- The Standard & Poor’s 500 lost 2.1% last week and the MSCI EAFE index of international markets declined 2.7% in U.S. dollar terms. The dollar rose versus the Euro and was flat versus the Pound, but declined versus the Yen. The ten year treasury yield fell to 2.91% while the two year yield declined to 0.36%. Gold rose 3.0% and oil declined 0.5%.

Other Economic News Last Week

-The trade deficit widened more than expected.

-Retail sales were slightly higher in June.

-The consumer price index declined 0.2% in June and the producer price index fell 0.4%.

-Eight European banks failed the EU stress tests.

The following is not intended to reflect any specific investment portfolio managed by WheelerFrost Associates, Inc. or to provide investment advice. Investment recommendations made by WheelerFrost Associates, Inc. are given only on a client  by client basis in conjunction with a specific investment plan.

Current Outlook

-          We are maintaining a “neutral” view of stocks with a cautious outlook, given the uncertainties arising from the budget standoff in the U.S. and the sovereign debt crisis in Europe.

-          Developed countries appear attractive versus the U.S. on valuation criteria.

-          Emerging countries appear attractive versus the U.S. on growth criteria.

-          Favor commodity exposure as a hedge against commodity induced inflationary pressures.

-          Corporate and mortgage-backed bonds are favored over treasuries.

-          Municipal bonds have rallied substantially from panic induced levels earlier in the year but remain relatively attractive compared to treasuries.

-          Favor State General Obligation municipal debt as well as essential services issues.

Risks

-          Higher oil prices due to Middle East turmoil and emerging country demand.

-          Potentially over-stimulative Fed policies and rising commodity prices are inflationary threats.

-          Debt levels and budget deficits in developed countries pose threats to sovereign debt.

-          Credit conditions remain challenging for individuals and small business.

-          Inflation concerns in emerging countries are forcing monetary tightening that could lead to slower global growth.

-          Renewed housing weakness threatens to weaken an already weak recovery.

This review is compiled from various research sources and nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. While WheelerFrost Associates, Inc. has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein. Information provided reflects WheelerFrost Associates, Inc. views as of a particular time. Such views are subject to change at any point and WheelerFrost Associates Inc. shall not be obligated to provide notice of any change.