If the drama in Washington rattles markets, here's what investors should buy.
America is two weeks away from defaulting on its debt, dramatists in Washington say. Fortunately, this crisis is as phony as a million dollar bill, which is why Treasury bond prices have barely flinched, which in turn is why the players involved will mug for the crowd until the last possible moment before striking a deal.
That doesn't mean investors should shrug the whole thing off. As Monday's steep decline in the Dow Jones Industrial Average showed, fake crises can produce real losses for investors. They can also provide some excellent buying opportunities.
In brief, there are at least four reasons not to fear a U.S. default. First, the debt limit America breached in May and must raise by Aug. 2 is an artificial barrier created by Congress mostly so that its parties can scold each other every so often about having to expand it. They have done so 11 times since 1940 (and many more times through extending deadlines and stretching definitions). Second, world demand for U.S. Treasury bonds remains ample, with China, Japan and Britain raising their holdings of late.
Third, under the gloomier of two sets of long-term projections by the Congressional Budget Office, federal debt won't hit unprecedented levels relative to the size of the economy until at least 2025. Fourth, as I've noted before, the U.S. budget shortfall isn't nearly as worrisome as European ones because America overspends on health care and defense by preposterous margins, and can therefore extract vast spending cuts from a handful of painless reforms the moment it musters the political will.
Of course, the U.S. can't necessarily prevent a threatened downgrade of its credit rating by Standard & Poor's, Moody's or Fitch. But if the Treasury market is impressed with the opinions of those firms, it hasn't demonstrated it. The 30-year yield rose Monday, but the 10-year yield recently slipped below 3%. That's less than half its average in Fed data going back to the Korean War.
Such low rates make Treasury bonds unappealing at the moment, despite their credit safety. Corporate bonds look similarly overpriced but municipals are somewhat more attractive by comparison, with tax-free yields of 3.2% on 10-year, A-rated issues. Shares of large, multinational companies look cheap, meanwhile. The largest 5% of U.S. firms by stock market value trade at a modest 13 times this year's earnings forecast and carry an average dividend yield of around 3%—half again as high as the broader market's yield. AT&T (NYSE: T - News), Pfizer (PFE - News), Philip Morris International (NYSE: PM -News) and Intel (NASDAQ: INTC - News) pay an average of 4.3%.
Gold topped $1,600 an ounce Monday, up 8% since the start of July. It might gain more, but what gold can't do is provide its owners with income or any intrinsic justification for its price. Those are two sources of much-needed support when asset prices broadly fall. Investors who are keen to hold commodities should consider dabbling in a diversified basket of grains, energy and metals, like the PowerShares DB Commodity Index Tracking fund (DBC - News).
Among the best things to hold during a phony default crisis is cash. It pays next to nothing, but the dollar looks cheap relative to the euro based on purchasing power parity (a comparison of local costs) and if policy makers in coming days overplay their role and rattle foreign creditors, bonds might swoon and offer better yields, and shares might tumble in the U.S. and abroad. Long-term, however, all the breast-beating in Washington is a promising sign. It means law-makers are properly serious about the importance of deficit cuts. If the drama creates bargains in the near-term, here's hoping the results are worth it.
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