Domestic high-quality, intermediate-term bonds gained 4% in the third quarter and are up 6.6% year to date, driven by investors’ flight to the relative safety of Treasuries. Developed-market international bonds were up 2.4% for the quarter and have gained 6.5% year to date. Local-currency emerging-markets bonds dropped significantly in September as capital flowed out of emerging-market currencies, and ended the quarter down 8.5% and are now in the red by 2.2% year to date. Floating-rate loans fell 3.9% in the quarter and have lost 1.4% year to date.

Since 2008, we have been in a period where macroeconomic forces are particularly influential on strategy. This quarter’s developments – in which we saw heightened concerns about a global economic slowdown, political gridlock, and serious concerns about shorter-term European and longer-term U.S. debt problems – are consistent with the risk scenarios we’ve been concerned about for the past several years.

Spooked by macro events, investors have flocked to Treasuries, forcing their prices even higher and their yields lower. Scary headlines and market volatility, while unnerving, can also create buying opportunities for disciplined investors.

These shorter-term macro swings could well continue in both directions for a long time to come given the ongoing macro challenges and uncertainties we face.

Investment Outlook

Politics and Policy

One of the challenges for investors today is that government policy is likely to determine the path taken by the global economy. This creates tremendous uncertainty because not only is it impossible to predict what will be decided by legislative bodies, it is also difficult to have confidence in what the ultimate effects of those decisions will be.

The past three months saw much debate and little progress on the U.S. fiscal deficit, as topics like tax policy continue to be very polarizing. The debt ceiling showdown earlier in the summer was the quarter’s most dramatic example of politics contributing to general uncertainty. Despite an 11th hour agreement, the contentious process and lack of meaningful action seemed to drive down consumer confidence and were specifically cited as part of the reason for Standard & Poor’s subsequent decision to downgrade the U.S. sovereign debt rating from AAA to AA. (The downgrade didn’t reflect any new information about the debt challenges we face as a country and so we don’t view the actual decision as a highly material development, despite the fact that it coincided with a sharp downturn in stocks immediately after the news.)

Overall, we continue to view policy mistakes, or simply inaction, as a major unknown and a potential risk factor. Too much austerity too soon could prove counterproductive (as was the case in 1937 when austerity measures tipped the country back into recession) and reduce tax receipts by a greater amount than spending cuts, thereby worsening the deficit problem. But, failure to address the deficit and debt in a meaningful way runs the risk of markets forcing the issue: investors demanding higher returns for taking on the risk of owning U.S. debt, forcing interest rates higher and further choking off growth, not to mention raising the cost of servicing our debt.

Meanwhile, with fiscal policy stalled by politics, monetary policy has been more aggressive with the Federal Reserve deploying a range of experimental tactics for boosting the economy. The quarter began with the end of QE2, the Fed’s second bond-buying campaign, and it ended with Operation Twist, by which the Fed will in effect exchange short-term debt on its balance sheet for long-term debt in an effort to reduce long-term interest rates and encourage lending and investing. The Fed has also made an unusually explicit commitment to keeping rates low until at least 2013. All of these efforts represent extraordinary measures intended to further the Fed’s dual mandate of ensuring price stability (which today means fending off deflation and avoiding runaway inflation down the road), and fostering full employment.

Our view is that monetary policy is not likely to help the economy much in the long run. We continue to believe the problem isn’t that we have overly tight monetary conditions, but that we have stalled liquidity as banks, corporations, and consumers hang onto their dollars rather than spending or lending them into the economy.

Debt Reduction Update

Despite the increasingly heated rhetoric of recent months, little progress has been made toward bringing down the government deficit and debt. The compromise agreement that enabled Congress to raise the debt ceiling promised some deficit reduction, mostly coming after the 2012 election. Nearer term, the budget reduction it effected is minimal and the plan puts off the inevitable decision to raise taxes, cut entitlements (Medicare in particular), or some combination of both, without which the deficit will reach unsustainable levels.

There has been some progress in bringing down the level of consumer debt relative to income, which is necessary for the economy to again grow at a healthy rate. But, government debt continues to grow. Ultimately, we think it could be close to a decade before overall household and government debt levels are reduced to a point where we can expect a more normal level of ongoing economic growth.

Debt and the Eurozone

European government debt problems are one of the other big-picture issues with potentially huge ramifications for the economy and financial markets. Investors grew increasingly concerned about Greece in recent months but also, more worryingly, about the larger economies of Italy, Spain, and even France, as well as European banks due to their exposure to European government debt. We share the view of most experts that Greece cannot repay its debt without some kind of restructuring, which is a deliberate euphemism for default. The question comes down to whether it is an orderly default, which can be managed in a way that avoids a damaging contagion effect that brings down other governments and/or banks, or a disorderly one, in which all bets are off.

As has been the case all along, we worry that markets may essentially force a resolution to Europe’s debt issues by driving up bond yields (and therefore funding costs) to a level that would push the weaker eurozone nations (Greece, Portugal, Ireland) toward default and could also force Spain and Italy into a liquidity crisis and potential insolvency. We expect central banks to step in to provide liquidity but, even with support, this scenario (or a less severe version of it) would be a harsh economic shock at a time we can ill afford it.

China

We continue to lean toward the more pessimistic/skeptical opinion that China is experiencing unsustainable real estate growth which, once the balloon is pricked, would result in a sharper and quicker slowdown in economic growth than what investors are expecting. It is also the case that China, like emerging markets overall, is not immune to the slowdowns in the U.S. and Europe as these markets are key sources of demand for goods produced there. But our long-term positive view of emerging markets remains intact even as the nearer-term period may see slower growth. Recently, investors have seemed to recognize the potential for an economic slowdown and emerging-markets equities have taken a beating.

Conclusion

The quartet of politics, Eurozone, China and debt have created a macroeconomic overhang that is impossible to predict what the effects will be and how long will they last.  Caution is advisable while we wait to see the opportunities whenever they show themselves. 

Keeping your estate planning documents up to date is essential in the event something happens to you and you are unable to make the decisions regarding your finances.  Having an up to date Power of Attorney is very important especially when you consider who will control my finances.

A few things to consider are: 

• Set it up early before you become incapacitated.
• Keep it current.  Renew and update your agreement regularly.
• Build in controls such as multiple children signing off.
• Prepare separate documents for each state you spend time.
• Set up a fallback trust to kick in.
• Check with your financial firm.
• Keep it under lock and key.
• Restrict the power.
• Plan for gifts.
• Cover your IRA.

We recommend that you consult your attorney for help with this vital decision.  If we can assist in any way, please do not hesitate to contact us.