Debt limit, plus economic moats, three-legged investing stool, and U.S. vs. Int'l equities
The Sandbox Daily (5.17.2023)
Welcome, Sandbox friends.
Today’s Daily discusses:
debt ceiling deadline causing fears of default risk
economic moats
the three-legged investing stool
changing of the tides?
Let’s dig in.
Markets in review
EQUITIES: Russell 2000 +2.21% | Dow +1.24% | Nasdaq 100 +1.22% | S&P 500 +1.19%
FIXED INCOME: Barclays Agg Bond -0.15% | High Yield +0.27% | 2yr UST 4.156% | 10yr UST 3.579%
COMMODITIES: Brent Crude +2.59% to $76.85/barrel. Gold -0.33% to $1,986.5/oz.
BITCOIN: +1.83% to $27,385
US DOLLAR INDEX: +0.29% to 102.857
CBOE EQUITY PUT/CALL RATIO: 0.68
VIX: -6.23% to 16.87
Quote of the day
“The amount of time you have been performing a habit is not as important as the number of times you have performed it.”
- James Clear, Atomic Habits
Debt ceiling deadline causing fears of default risk
U.S. Treasury Secretary Janet Yellen continues to warn members of Congress and the American public that the Treasury expects to be able to pay the U.S. government's bills only through June 1st without an increase to our country’s debt limit, heaping pressure on Republicans in Congress and the White House to reach a deal in coming days.
In January, the $31.4 trillion debt limit – the amount of debt the U.S. government can hold – was reached and cash reserves could be exhausted by June 1. A default on government debt would likely leave millions of Americans without income payments, potentially triggering a recession that could destroy many American jobs and businesses. The graphic below charts the recent 50 years of our debt ceiling and its sharp rise as a ratio of GDP.
With roughly two weeks to reach an agreement, the market is concerned that a technical default will rattle markets and cause asset prices to decline precipitously, just like 2011. As the world’s reserve currency, any default on U.S. Treasuries would be devastating. If its role as an ultra-safe asset is undermined, a chain reaction of negative consequences could spread throughout the global financial system. Often Treasuries are held as collateral – if these debt payments fail to get paid out to bond investors, the very core of the global financial system will be disrupted.
Investors have factored in this risk of default. The cost of insuring U.S. debt against a default – via a credit-default swap (CDS) contract over the next 12 months – has soared to the highest on record, reflecting the uneasiness that persists in the bond market.
2023 CDS spreads have risen higher than the 2011 debt-ceiling showdown and subsequent Standard & Poor’s downgrading of the AAA credit rating, as well as the debt-ceiling dramas played out in 2013, 2015, and 2021.
Source: Visual Capitalist, Bloomberg
Economic moats
Some investors only invest in companies with a sustainable competitive advantage over its competitors – a wide “economic moat” – that allows it to protect and increase its long-term profits and market share.
These companies are clear market leaders with strong pricing power. Those companies are often characterized by high and stable gross margins as well as high and stable Returns On Invested Capital (ROIC).
There are different kinds of moats, but they often can be broadly grouped across a few key principles: switching costs, network effects, cost advantages, efficient scale, and intangible assets.
Warren Buffett once stated that the company itself can be seen as the equivalent of a castle and the value of the castle will be determined by the strength of the moat.
In other words: the moat protects those inside the castle and prevents outsiders from entering the fortress.
Source: Brian Feroldi
The three-legged investing stool
An overly simplified investment strategy that applies to many people is the three-legged investing stool, where your financial assets are divided across three buckets: 1) preservation, 2) income, and 3) growth.
Each bucket has its own defined risk and return objectives, time horizons, liquidity constraints, asset mix, and the appropriate tools and solutions that must be applied. Ultimately, the investment strategy you apply will depend on your goals.
The Preservation bucket includes funding immediate goals and needs that must be met, requiring the investor to assume little to no risk. This bucket includes things like cash, money market funds, short-term Treasuries and bond funds, and insurance.
The Income bucket addresses the need for ongoing cash flows, requiring the investor to take some risk in order to achieve a desired yield. This bucket includes things like bonds, real estate, MLPs, structured products, preferred stock, dividend-paying stocks, and annuities.
The Growth bucket tackles the need for wealth accumulation, requiring the investor to take on more risk than anywhere else in their portfolio so that assets can grow and compound over time. This bucket includes things like stocks, hedge funds, and private equity.
Source: SoFi
Changing of the tides?
There has been no place like the United States when it comes to global equity market performance over the last 15 years.
Technology sector dominance, exerted by some of the world’s largest companies, such as Alphabet (GOOG/L), Apple (AAPL), Meta (META), and Microsoft (MSFT), has helped propel the S&P 500 Index (SPX) to outperform the MSCI EAFE Index (MXEA) during 11 of the last 15 calendar years. A sustained rebound in domestic growth following the Global Financial Crisis, economic stability, strong earnings growth, relatively low interest rates and inflation, and fewer geopolitical headwinds have been other key drivers of U.S. outperformance.
However, the tides appear to be changing as evidence builds for a shift toward international developed market outperformance. Recent dollar weakness, absolute and relative valuations, weak positioning in these markets, and the technical backdrop are all supportive drivers for further strength abroad.
Source: LPL Research
That’s all for today.
Blake
Welcome to The Sandbox Daily, a daily curation of relevant research at the intersection of markets, economics, and lifestyle. We are committed to delivering high-quality and timely content to help investors make sense of capital markets.
Blake Millard is the Director of Investments at Sandbox Financial Partners, a Registered Investment Advisor. All opinions expressed here are solely his opinion and do not express or reflect the opinion of Sandbox Financial Partners. This Substack channel is for informational purposes only and should not be construed as investment advice. Clients of Sandbox Financial Partners may maintain positions in the markets, indexes, corporations, and/or securities discussed within The Sandbox Daily.