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America's Debt Problem Slows the Economy

Stocks in this article: MCO SH PSQ EUO TBT

BOSTON ( TheStreet) -- Investors are disappointed with the latest read on gross domestic product, but for the wrong reason.

The government cut its third-quarter GDP estimate to 2% from a previous 2.5%, helping to pare gains in the stock market today.

Super Committee Co-Chair John Kerry (D-Mass.)

Weak inventories are to blame. Reuters notes that the first revision to the third-quarter GDP estimate shows an $8.5 billion drop in business inventories, which lopped off 1.55 percentage points from GDP growth.

To some investors, though, a slower economy underscores the bigger problem of U.S. debt, a particularly sore subject for investors after the so-called 12-member congressional Super Committee failed to find $1.2 trillion in deficit cuts after 10 weeks on the job.

"You have to reduce the overall debt level. That is going to be the key to any future growth," say Paul Nolte, director of investments with Chicago-based Dearborn Partners. "If you can't do that, you're not going to get economic growth."

The debt burden, as measured by the debt-to-GDP ratio, is around 100%, which is a concern to investors such as Nolte.

"We're rapidly approaching the tipping point, where it can consume GDP," Nolte says. "We've been in a period for the last 30 years or so when we've seen a rising debt-to-GDP level. But the growth in debt continues to be the No. 1 concern for economists and investors."

Nolte isn't alone in his worries over Congress' inability to address the deficit and bring down the debt-to-GDP ratio in the U.S. Jeffrey Sica, head of Morristown, N.J.-based Sica Wealth Management, points out that the U.S. deficit has increased by $500 billion since the formation of the Super Committee three months ago.

While gross domestic product in the U.S. may be increasing by 2%, the debt-to-GDP ratio is climbing at a faster rate.

"As long as they keep raising the debt ceiling, if they don't get GDP numbers that consistently exceed expectations, there's no relevance," Sica said in an interview Monday. "You would need to see astronomical growth in GDP."

Sica, whose firm manages about $1 billion, says ballooning debt means credit-rating agencies Moody's (MCO) and Fitch Ratings will downgrade U.S. debt to AA+ from AAA, much like Standard & Poor's did in August. If the debt-to-GDP ratio grows to 120% as Sica predicts, it would make an economic recovery highly unlikely for the next three years.

"It creates a very strong possibility of a prolonged recession that will be very difficult to dig out of," Sica says. "The compounding effect is very evident now."

This will create a poor investment environment, Sica says. "I expect a very bad 2012," he adds. For that reason, Sica has completely sold out of equity positions for his clients. Instead, Sica has been sitting on cash, with short positions on U.S. Treasuries and the stock market.

Sica says his firm's portfolios are essentially cash and short-oriented. He is currently in the ProShares Short S&P 500 (SH) ETF, the ProShares Short QQQ (PSQ) ETF and the ProShares UltraShort Euro (EUO) ETF. Those have generated returns, Sica says, even though he's only about 15% short.

And while Sica acknowledges there is still a rally in U.S. Treasuries, it's short-lived. That's why he's been buying the ProShares UltraShort 20+ Year Treasury (TBT) ETF. Although the ETF is off by 50% this year, Sica calls it a timely investment.

Similarly, Nolte says investors would be wise to avoid equities altogether in a deflationary environment.

"As an investor, you don't want to be playing around in the equity market," Nolte says. "You'd rather be playing in fixed income because you're starting to see a deflationary cycle. You're not going to have high levels of inflation where purchasing power erodes. In deflationary, fixed income should perform relatively well."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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