On the other hand, the political dialogue has moved in the direction of budgetary restraint which is clearly a positive development.

At Next Generation Wealth Management, it has been our view that the longer-term fiscal debate wouldn’t be determined around this debt ceiling discussion and that debate will be the focus of the 2012 Presidential election. This agreement should take the question of default off the table through the election, deferring the big questions on spending and taxes until 2013. In this report, we will analyze the deal that was struck, discuss why it is so important, address the relative standing of the United States and the U.S. dollar, review the outlook for interest rates, and discuss potential industry winners and losers.

A SUMMARY OF THE DEAL

The Table below provides a summary of the key items agreed to in the debt ceiling plan. Importantly, the agreement includes provisions that allow an increase in the debt ceiling totaling $2.4 trillion, which should allow funding through 2012. It is critical to understand that this is not the authorization to spend additional monies – it is just creating the ability to pay bills we already have incurred or will agree to incur going forward. The collective spending cuts of $2.417 trillion agreed to modestly exceed the debt ceiling increase, but are heavily dependent on the $1.5 trillion of cuts that a Congressional committee must agree to by November 23. The plan includes, as a trigger for action, an automatic $1.2 trillion in budget cuts (half from defense, half from domestic spending) if the committee doesn’t meet its deadline.

HOW DOES THE UNITED STATES COMPARE TO OTHER COUNTRIES?

Relative to other major economies, the expected default risk of the United States is relatively low. The United States compares well against its major currency competitors [the euro and yen], as risks to Germany are higher than in the United States due to their contingent liability for much of the rest of Europe, and Japan’s are measurably higher as a result of their high debt levels | weak demographic outlook. Generally speaking, we believe the global financial markets continue to give the United States some flexibility to tackle our debt challenges. The recent financial crisis has changed the whole analysis of the global economy, growth and credit risk.

THE U.S. DOLLAR

Concerns over the value of the U.S. dollar have been high since even before the peak of the financial crisis. Surely, the United States’ large trade deficits, fiscal imbalances and loose monetary policy should lead to a falling currency. Relative to our trading partners [as measured by the trade-weighted dollar exchange rate], the dollar has fallen from a level of 88 in February 2009 to the current level of 74, a decline of 16%. Declines against currencies such as the Brazilian real and the Swiss franc have exceeded 30%. So the U.S. dollar has been losing relative purchasing power versus these currencies, yet U.S. policy makers have expressed no great discomfort with this depreciation. Why is this so?

First, the currency depreciation has not caused meaningful negative implications to our economy so far. Interest rates have remained remarkably contained while inflationary trends are not worrisome. Instead, the United States has enjoyed booming exports – a lonesome outperformer in an otherwise weak economic recovery. One of the significant benefits of flexible exchange rate systems is the rebalancing effect currency adjustments can facilitate. Conversely, one of the major weaknesses of the European Monetary Union where countries in financial difficulties [e.g., Greece], is that they are tethered to a relatively strong currency that doesn’t adjust to improve their international competitiveness. Instead they are left with “internal adjustments,” such as punishing austerity measures, as their primary policy path.

INTEREST RATES

Our team continues to believe the outlook for interest rates in the developed economies is fairly benign for an extended period. As we have previously stated, we believe the outlook for growth and inflation are the primary drivers of interest rates. Historical evidence in both the U.S. fixed income market does not indicate a correlation between deficit levels and interest rates.

Additionally, we believe the effect of a ratings downgrade on U.S. interest rates will be relatively minor. We do not see money market funds being forced to liquidate U.S. debt, however, volatility in the Treasury market may be elevated [similar to the European experience], as legislators address the longer-term budget challenges. There will likely be some increasing diversification by Global investors, who will likely diversify away from U.S. Treasuries but we do not expect an immediate transition from this investment due to the continuing reserve currency status of the U.S. dollar and the level of savings being created by deleveraging.

THE FINANCIAL MARKETS

Many areas of the financial markets will be impacted by policy maker’s efforts to reduce our debt burden, including: the potential closing of corporate tax loopholes and expiration of payroll tax cuts and their related effect on corporate and consumer spending. However, there are a few areas which are affected more directly – most notably, healthcare and defense. Unfortunately, we do not see any industries that will particularly benefit from the debt ceiling agreement.

Within healthcare there appear to be some areas that remain sacrosanct under the proposed legislation, including: individual benefits under Social Security, Medicare and Medicaid; veterans’ benefits and pensions; civil and military pay; and Women, Infants and Children’s [WIC] programs. While individual benefits under Medicare and Medicaid are protected, providers of medical services, such as physicians and hospitals, would be subject to cuts. The overall reduction to Medicare is expected to be approximately 2%. Direct federal spending on drugs, biotech and high tech medical devices will remain largely intact, for now.

We note there are two other risk factors. The joint House | Senate committee that must find an additional $1.5 trillion in savings over a decade might not view Medicare and Medicaid as sacred and may make cuts in these programs, negatively impacting the healthcare industry broadly. A second risk is that, if the committee cannot agree on at least $1.2 trillion in budget cuts, spending cuts would automatically take place across the federal budget – again affecting doctors and service providers. As is currently being discussed, however, Medicare and Medicaid [as well as Social Security, certain veterans’ benefits, and federal employee retiree benefits] are exempt from cuts.

Regarding the defense industry, initial cuts to defense spending of $350 billion over 10 years are roughly in line with the $400 billion over 12 years proposed by President Obama this past spring. The worst-case scenario for a second round of cuts is another $500 billion over nine years, assuming the joint commission is unable to come up with a plan. Veterans’ benefits and military pay are both exempt from the second round of cuts, indicating procurement accounts will bear the brunt of the cuts – a clear negative for the defense industry. The total $850 billion of cuts over 10 years is well above the $400 billion suggested by President Obama, but not as bad as the $1.1 trillion suggested by an earlier Senate plan. A possible offset to this negative news is that the cuts come over 10 years, and the world is still a dangerous place [unfortunately]. These are not post-Cold War spending reductions like we saw in the 1990s. Events during the coming years may require higher spending on defense to ensure our military capabilities can handle threats to U.S. interests at home and abroad.