Can Government Spending Drive Your Portfolio?

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In periods of global economic growth, investing seems so straightforward: focus on company fundamentals, buy with discipline, and watch your moolah grow.

No big deal, right? Yet despite your advancing gains, persnickety economists continue to yap about yield-curve this and GDP percentage that. Thank you kindly, Mr. Pundit, but my portfolio is doing just fine.

Fast-forward to the present: the global party bus has slammed to a halt. Your investment returns, having been hurled from the vehicle, still reside at the bottom of a cliff. As you look down at the wreckage, you think "gee, maybe it wouldn't hurt to brush up on the macroeconomic scene."

The fundamentals of government stimulus
The relationship between economic phenomenon and investment strategy, Fools, is a broad topic. But given the upcoming government spending spree, it appears particularly fitting to explore different economic perspectives in relation to the long-term performance of the uber-popular infrastructure sector. In the end, you may think twice before jumping to buy 100 shares of Caterpillar (NYSE: CAT) and a toy dumptruck. Here are three scenarios:

Take No. 1: Cartwheels and pom-poms
I've seen some experts claim that President Obama's stimulus package is the definitive road to a mid-2009 recovery. The rationale goes that the government, in times of gross economic funk, becomes not only the buyer of last resort, but the spender, too.

Say Uncle Sam hires ABB (NYSE: ABB) to overhaul the electrical grid into the 21st century. Uncle Sam's dollar becomes ABB's dollar, which becomes an employee's dollar, which is spent at a store -- a store that buys from a supplier that in turn purchases from a raw materials producer, and so on. Before you know it, this "multiplier effect" has the whole economy humming.

Given this model, diversified infrastructure and industrial names such as Eaton (NYSE: ETN) and Emerson (NYSE: EMR) appear to be long-term portfolio heroes: I mean, hey, a government-financed building boom followed by a chug-a-lug economy? Sign me up!

Take No. 2: Nice, but not enough
Nobel Prize-winning economist Paul Krugman recently cleaned out the lockers of the cheerleaders when he wrote a New York Times op-ed piece that said the country is likely facing $2.1 trillion in lost production over the next two years, to which a stimulus plan of less than $1 trillion does not adequately respond.

Referencing the multiplier effect, Krugman endorses estimates that each dollar of government spending correlates to $1.50 in GDP. This figure would be insufficient even if the full stimulus were in spending, notes Krugman, who goes on to point out that 40% of the proposed government package looks to be in tax cuts. Krugman questions whether generous tax policies can truly goose business spending. Like banks that appear to be hoarding TARP money, might companies just sit on their new-found cash?

If we accept Krugman's outlook, conglomerate Honeywell (NYSE: HON), with its exposure to the ultra-economically sensitive housing and automotive sectors, may be less "buy" and more "watch list."

Take No. 3: Cue up the John Mellencamp
That's right, this opinion has the walls a-crumblin' tumblin' down. Known as the Austrian School, proponents of this perspective point out that there is no free lunch: Every dollar of government spending has to be paid for, and you, the taxpayer, will be doing the paying.

What's more, a dollar spent in one sector is a dollar that cannot be spent in another. Problematically, the dollar spent is visible to all, which makes the nation feel good; whereas the dollar that therefore cannot be spent on a different need is hidden, yet still a loss.

To sum up this thinking, the nation gets an illusory economic lift that inevitably crumbles into a growth-killing period of super-high taxes. Interestingly, President Obama's director of the Council of Economic Advisors, Christina D. Romer, recently co-authored a paper that examined the relationship between tax changes and GDP. In regard to the type of tax hike that includes a deficit-driven increase, Romer concluded that a tax increase of 1% of GDP pares real GDP by nearly 3%.

Yikes! If this scenario were to play out, successful infrastructure-related stock picking would likely hinge upon your ability to sell, sell, sell before the market reacted to the approaching tax cloud. Long-term investors would arguably be better off with retail behemoth Wal-Mart (NYSE: WMT) than any maker of high-priced hulking machinery.

Endless highway or dirt road tollbooth?
Which view is right? You got me. My advice, though, is to take the middle road. Question government stimulus both as a cure-all and an absolute evil, and recognize that the future is probably somewhere in between. In that light, it could be most prudent to focus on companies such as Esco Technologies (NYSE: ESE) that serve the utility sector, an area that should continue to require upgrades regardless of the economy's macro trend.

If you do decide to venture into the arena of heavy metal and earth movers, I advise focusing on companies that boast low relative debt and a history of flexible capital spending and good employee relations. And given the volatility in the sector, strict adherence to target entry points will help keep you safe from falling objects.

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