Selective Analysis and Faulty Conclusions

China raised interest rates today. The European Union has raised rates and is preaching austerity. The US has ended QE2, the Fed has become quieter, and Congress is wrestling with spending cuts and austerity plans of our own. Global tightening does not a growth environment make.

On the bright side, some economic data is improving and, unfettered by additional shock waves, may continue to improve thanks to a sell-off in commodity prices, lower interest rates, and a rebound from the devastating effects of the Japanese earthquake and tsunami. Recent manufacturing indicators have been better, and exports have been strong owing to a weaker dollar and continued strong growth in emerging economies. We are more and more dependant on economic growth in other parts of the world.

I feel like investors are doing selective, petal-plucking analysis: she loves, me she loves me not. This is a good economic number, and that is a bad one. If we have the wrong number of petals, we could be in trouble.

Last week we wrote that the debt ceiling has to be increased, and we received several email responses objecting to my liberal, free-spending position. (Little could be further from the truth.) I am all for spending cuts, fiscal responsibility and living within our means. Not only am I supportive, but I have been preaching this gospel for many years. However, the notion that the debt limit should be left in place in an effort to force difficult budget decisions by August 2nd is both monochromatic and naïve. Folks are horribly misguided in their understanding of what will happen when; beginning on August 2nd, our ability to pay our bills comes down to only the funds available from daily receipts. Not only will we fall short by about 33% for the month, but ongoing receipts and payments will continue to be very lumpy and mismatched. My friend Jay Powell has done a brilliant and very sobering day-by-day analysis of every line-item cost. The simple fact is that we as a country will risk going into default on our debt. The upcoming debt limit is NOTHING to be trifled with.

The final week of the 2nd quarter felt like the normal risk-on rally. It may be that the debt limit increase passes, and averages move a good deal higher again with a pretty good rally in banks and consumer discretionary names. In spite of the risk pattern repeating and a similar feel, I think the current absence of QE should mean that the risk trade is off. Greece will ultimately default, and the collateral European banking maelstrom could be the sort of shock that carries an anemic recovery back into recession.

As I look to the next six months with the responsibility of stewarding other people’s financial interests, I see exciting potential rewards if the world remains sunny and well. But the combined domestic and global risks are too great to go all-in. Most importantly the US consumer (who’s spending accounts for about 70% of GDP) is facing formidable challenges the likes of which we haven’t seen in decades. As the multi-year process of deleveraging continues, I’m staying defensive and holding on to my multi-national blue-chips with good dividends.

My family celebrated my grandmother’s 103rd birthday last night. She had her hair done and bought a new dress. Amazing! She reminds all of us that there is a great deal more to life than the financial markets, and no matter how tough things seem, things heal and time marches on. America will continue to grow over time and remain a formidable economic force. It just may not happen between commercial breaks.

Hang in there,