A Budget Deal is Taking Shape -- Here's what Investors Need to Know

David Sterman's picture

Wednesday, July 20, 2011 - 1:00pm

by David Sterman

Waiting until the last minute, the politicians that run the United States of America are finally on the cusp of a major government overhaul -- a move that was badly needed in light of its eye-popping budget deficits. Yet while the move to finally trim budget deficits should be applauded, investors may be underestimating the impact a major deal will bring. By sharply cutting spending while also closing certain tax loopholes, major portions of the U.S. economy will be heavily affected, and you need to adjust your portfolio accordingly.

The highlights of the emerging deal include:

  • Reduce the current $14 trillion debt by about $3.5 trillion during the next 10 years. This would reduce the size of the federal debt to 70% of GDP by 2021, or around $10.3 trillion
  • Ensure the solvency of the Social Security system for the next 75 years
  • Increase the efficiency of health care spending
  • Eliminate the Alternative Minimum Tax
  • Freeze or reduce funds in every area of discretionary spending
  • Close a range of tax loopholes

These concepts all come from the outline issued by the bipartisan "Gang of Six" Senators, that I've written about previously, who sought to exact compromise son both sides of the aisle.

Unfortunately, their outline is maddeningly vague, helping Washington to announce an agreement before the specific details can be worked out. Let's give politicians the benefit of the doubt and assume they'll eventually show the courage and clarity to finally bring a permanent end to this financial mess that has been created. We have a pretty clear sense of how Washington can meet the goals laid out above, and it's time to think about what it means for your investments.

The retirement game-changer
The slow death of corporate pension plans gave rise to the self-directed retirement plans offered by firms such as T. Rowe Price (Nasdaq: TROW) and Fidelity Investments. Coming changes in the Social Security system promise to make consumers take even greater control of their retirement. To make the system "solvent for 75 years," the amount paid out in benefits will have to shrink. Right now, you can start collecting benefits at age 62, and if you wait another five years, you'll be eligible for more robust monthly payments.

Although politicians will speak of only a modest upward move in those age thresholds, look for a more aggressive push within a few years as it becomes increasingly apparent the United States has a rising tide of octenagarians and nonagerians (people in their 80s and 90s). The longer these folks live, the greater the pressure on the whole system. That's why I look for those age thresholds to eventually rise by five years, meaning you'll need to wait until you're 72 if you want the most robust monthly payments, or at least 67 for those in need of smaller payments as soon as possible.

Privatization of infrastructure
As the government shrinks, look for funds dedicated to roads, mass transit systems and airports to shrink. To avoid a backlash that comes from pot-holed roads, aging subway cars and other transit headaches, look for the government to seek asset sales wherever possible. This may include highways which become private toll roads, a privatization of Amtrak or a long-term lease to run our major airports. Australia's Macquairie Group (Pink Sheets: MQBKY) is a leading global operator of privatized roadways and airports. Look for major U.S. financial services firms such as GE Capital, the finance arm of General Electric (NYSE: GE) to get in on the action as well.

A "peace dividend" without peace
The ground underneath the defense sector is slowly crumbling. Republican leaders initially sought to spare the Deptartment of Defense from the budget axe, but deficit hawks within the party have signaled a willingness to put this sacred cow on the chopping block as well. While current discussions are focused on very modest cuts to defense spending, President Obama has reportedly tasked new Defense secretary Leon Panetta with finding major areas of savings.

The amount of active military service personnel could fall 5% or 10%, yet perhaps some of the greatest cuts may come from major new programs in the early development stage. These programs are the bread-and-butter of defense contractors such as Lockheed Martin (NYSE: LMT), General Dynamics (NYSE: GD) and Northrup Grumman (NYSE: NOC). Remarkably, these stocks still trade within 10% of their all-time highs. As the reality of deeper-than-expected cuts line up for defense spending, these stocks could really rotate out of favor.

The pain in health care has only just begun
It's been a brutal stretch for major healthcare companies. Big drug companies have had trouble finding new blockbuster drugs, and medical device companies such as Medtronic (NYSE: MDT) and Boston Scientific (NYSE: BSX) haven't posted organic growth in many years.

It's about to get worse. To contain and reverse spiraling health care costs, even as society ages and grows more infirm, the only solution will be to provide less government funds for the most expensive and advanced treatments. For example, Dendreon's (Nasdaq: DNDN) Provenge prostate cancer drug costs more than $90,000 a year to administer. It may only be a matter of time before such pricey remedies are only supported by private health insurance and no longer reimbursed by Medicare or Medicaid. This means the outlook for any firm selling a very expensive medical device or drug is about to get even bleaker.

The oil and gas windfall comes to an end
Thanks to ever-rising global demand, fossil fuel prices are likely to stay at current levels or move even higher. So there's a good case for owning stocks in the energy sector. Yet analysts' profit estimates may move a bit lower if plans to eliminate energy exploration subsidies are enacted. These subsidies can be a significant source of profits for some smaller oil and gas drillers, and you may want to closely read the 10-K filings of the stocks you own to see how much exposure your particular investment has.

The IT crash
The U.S. government is also the biggest purchaser of technology in the world, spending tens of billions of dollars annually on software, hardware and services. Yet this is a clear area for cost cuts because existing assets can simply be used for an extended period. In some instances, look for the government to actually shrink its footprint. For example, the United States plans to shut 40% of its 2,000 government-run data centers, according to The New York Times. This means it will have an excess of data servers that can be redeployed elsewhere when the need arises, and signals the government won't be buying any new data center servers for quite some time to come.

In the data center space, Verizon (NYSE: VZ) is a large player, thanks to its early 2011 acquisition of Terremark Worldwide. In terms of hardware, companies like Cisco Systems (Nasdaq: CSCO) will continue to struggle to find repeat business with the government. On the service side, firms like Computer Sciences Corp. (NYSE: CSC) look increasingly vulnerable.

Action to Take --> Looking beyond the specific investment areas at risk, investors need to brace for a potentially broader hit to the entire stock market. That's because Uncle Sam, which had been pumping money into the economy thanks to ongoing deficits, will actually withdraw funds form the economy as it looks to bring down the total federal debt by $4 trillion over 10 years. This negative stimulus is bound to create a drag on the U.S. economy, which is already mired in a low-growth mode.

Simply put, you need to follow the unfolding of events closely. As the details of a deal become ironed out, you'll need to seriously evaluate your portfolio and be prepared to make adjustments to compensate.

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.