July 14, 2010

Alan Levenson, chief economist at T. Rowe Price, comments on the fiscal future of the U.S.

The sovereign debt crisis in Greece and other peripheral European Union nations has been like a splash of cold water on the torrid rally in global financial markets that started in March 2009. Global economies and markets have improved significantly over the last year, thanks in part to the highly stimulative fiscal and monetary policies implemented by governments and central banks around the world. Recently, though, fiscal concerns of highly indebted countries have come to the forefront. As a result, market volatility has returned to levels not seen in more than a year, and some investors are growing concerned that the U.S. government's weakening fiscal situation could spell trouble ahead here at home.

Although debt-related turmoil in Europe has recently been a boon for the U.S. dollar and Treasury securities, Europe's efforts to contain the crisis have raised concerns about the U.S.'s ability to finance its debts over the long term. Some investors are considering the possibility that the U.S., which has had enormous budget and trade deficits for years, may one day find itself forced to make painful fiscal decisions to shore up its currency, reduce its outstanding debts, and/or keep interest rates from soaring. These could include higher taxes as well as deep reductions in government spending.

Providing benefits promised under Social Security and Medicare is also a concern. "The coming squeeze on these programs owes significantly to an aging population," says T. Rowe Price Chief Economist Alan Levenson. "These pressures are set to intensify within the next few years."

According to Levenson, total federal debt is currently poised to grow much faster than the economy over the long run. By 2020, federal debt as a percentage of gross domestic product could be as high as 90%, according to the Congressional Budget Office.

While Levenson does not believe that a U.S. government debt or dollar crisis is imminent or inevitable, he does acknowledge that the U.S. dollar's reserve currency status may not protect the U.S. from the consequences of federal fiscal mismanagement. "Even if the U.S. dollar retains its role as the world's leading reserve currency for the foreseeable future, there could nonetheless be an interest rate premium to pay if global investors' enthusiasm for the dollar diminishes," says Levenson.

With market volatility apparently increasing and sovereign fiscal concerns becoming harder to ignore, some investors are considering portfolio changes that may hinder their efforts to reach their long-term financial goals. Among these changes are emphasizing short-term fixed income securities that are expected to be relatively stable or selecting certain commodities for perceived inflation protection.

T. Rowe Price's financial planners caution that if you invest too conservatively out of fear of short-term losses, you may miss significant long-term capital appreciation and could find that your asset values haven't kept up with inflation over time. "Doing what feels good financially in the short term may make you feel even worse in the long term," cautions T. Rowe Price Financial Planner Stuart Ritter.

On the other hand, if you emphasize investments that are expected to perform well in an environment of higher inflation, you could find that your portfolio is too focused on a specific outcome. If higher inflation fails to emerge or if events take place that affect your investments in an unexpected way, your portfolio could underperform the broader markets.

Uncertainty and concern about the future are nothing new. No one really knows what the future holds and how securities will respond to unpredictable future events. That's why maintaining broad portfolio diversification across investments that may perform well in a variety of market environments—including scenarios featuring higher inflation—is the most sensible course of action for long-term investors.

Most long-term investors' portfolios should have a significant but well-diversified commitment to equities—domestic and international, including emerging markets; growth and value; and small-, mid-, and large-cap—because they have historically performed better than most bonds and money market instruments over very long periods, albeit with greater volatility. Those who have shorter time horizons should have a greater commitment to fixed income securities—short, intermediate, and long term; government and corporate; high yield and investment grade; and U.S. and non-U.S.—that pay some income on a regular basis. These securities offer less return potential and tend to be less volatile than stocks.

Past performance cannot guarantee future results. Diversification cannot assure a profit or protect against loss in a declining market.