Playing with fire...

...describes well the dangerous games of partisan politics in the U.S.

Postponing a deal on the debt ceiling which is scheduled to expire in the beginning of August to the last minute is akin to playing with fire not because they will not strike a deal before the set deadline (they most likely will) but because the markets are right now at arms length of entering panic mode as tensions continue to build up. Our June newsletter outlines the so called "clear and present dangers" that are on the sidelines, waiting for that as yet unidentified catalyst that could trigger another dreaded crisis on the markets.

It should be noted that the U.S. debt debacle is taking place on the backdrop of a clearly worsening debt crisis in Europe, which is now showing signs of spreading to the bigger peripheral country economies of Italy and Spain. The reason why investors have become so jittery is because both Spain and Italy happen to be just too big to rescue.

Although stock market volatility rates remain subdued there is a clear "flight to quality" momentum that is building up as gold, the Swiss Franc and government bonds of countries perceived to be less affected by the debt debacle break records.

So what is one to do when the threat levels are just one notch before panic mode? Well, for one you should stick to the old adage of ensuring a sufficient degree of diversification. But you also run the risk of losing more through diversification if things suddenly improve. That is because the probability that things are going to get worse currently have a greater weight in the market pricing of assets than the probability that things will improve, so if things do improve and you are diversified into investments that are meant to protect the portfolio in bad times, those are the ones that will suffer the most. It is always easier to construct a portfolio in stable rather than unstable market conditions because the risk premium component of the value of an asset will be a smaller percentage of the total. So there is a timing element to diversification but that should matter less over the longer term.

On the horns of a dilemma...

At each cry of help, the powers that be are injecting a potent but short lived dose of life sustaining matter into the system, but this is unfortunately just another case of too little too late. The political setup of this European "experiment" is their "Achilles heel" that impedes them from doing what is needed to avoid a train wreck. With the record erosion of the Euro against the Swiss franc and European stock markets now firmly in negative territory there is little that can be done to stop contagion from spreading. Default is still in the cards but the more time passes the less likely that it can be conducted in an orderly manner.
Mind you, the U.S. is in its own mess too, still recovering from a colossal debt burden and no way out of it, other than to print more money to buy more time. Still, the fact that the U.S. enjoys both economic and political integration puts it at a major advantage to Europe, and right about now, the markets seem to agree with this.