–Well, now we know what last Friday’s big global sell-off was all about. Ratings agency Standard and Poor’s has downgraded the credit rating of the United States government from AAA to AA+. Let the fear and dread begin.
–What we don’t know is whether financial markets are nearing a state of total revolt against the Money Power. The decision by the European Central Bank to make huge government bond purchases with money it doesn’t have could cause a state of near panic. We’ll get to that in just a moment.
–But first, S&P becomes the first of the three major ratings agencies to tell the US government its credits aren’t any good (or at least not at AS good). It probably won’t be the last. The decision should not have surprised anyone in possession of conscious thought. We wrote as much a week before the downgrade in a note to Australian Wealth Gameplan readers (emphasis added is ours):
Let’s assume there will be no debt default in the US. This means a deal will get done before August 2nd. Of course, I could be wrong…But I think the more likely outcome of the next seven days is that a deal will be reached and the US will see its credit status downgraded anyway. After all, the ratings agencies looking at the last few months would have to conclude that there is no political consensus on real long-term debt reduction in the United States.
Divided government—when the Congress and the President cannot agree—is useful for bringing government to a screeching halt. But if there’s no real political will in America to begin living within its means, the quality of America’s credits must be marked down. The nation is simply not as credit worthy as it once was. You can tell by the behaviour of its politicians and its central bankers that it does not deserve the privilege of gold-plated credit and management of the world’s reserve currency.
The loss of an AAA sovereign credit rating will trigger the re-rating of trillions of dollars of debt instruments that have their value linked to US government bonds. And the de-facto loss of reserve currency status will accelerate the move by investors to diversify their portfolios into other currencies.
–Don’t expect the downgrade to trigger a sell-off in US bonds. “There is no change in Japan’s trust in U.S. bonds,” a senior Japanese official told Reuters. The US Treasury market is the deepest and most liquid fixed income market in the world. Even if it’s poisoned, investors will still drink from it. It’s the only pool of capital large enough to accommodate a very large herd of terrified global investors.
–Strangely, then, even though the US credit rating has been downgraded, expect to see investors flock to Treasury bonds and notes. They will sell “riskier assets” and buy liquid “safe” assets. Gold futures are up 2.5% as we write and just shy of US$1,700.
–Are Australian stocks and the Australian dollar considered “safe” assets? They weren’t in 2008. Will this time be different? Despite the China link, the capital markets are quite clear in their answer: this time isn’t different.
–We just had a brief chat with Slipstream Trader Murray Dawes. Murray’s calls on the market have been spot on for the last two months. You can watch his latest free YouTube update here. Murray and your editor both agree that investor’s are on the verge of losing total confidence in the powers that be to manage the financial crisis. That kind of emotional conclusion leads to huge down days in the market.
— By the way, S&P aid the long-term fiscal path of the US is a giant collision with reality that’s bound to happen. The US Treasury Department disputed S&P’s conclusions and said the ratings agency screwed up on its calculations by a few trillion bucks. But S&P fired back and replied that estimates of debt-to-GDP ratios were not the core motivator for its decision. So what was? S&P wrote:
The political brinkmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.
–So there’s “political risk” to investing in American bonds now. This goes hand-in-hand with the US dollar losing its status as the world’s reserve currency. S&P realises that no one in Washington takes those developments seriously. Or, that the lack of agreement on what to do about America’s debt problem means America is simply not as credit worthy as she once was. Who can really argue with that?
–The downgrade must have come as bittersweet news to America’s largest trading partner in crime, China. China owns $1.2 trillion worth of US bonds and notes. And China sits on $3.2 trillion in foreign-exchange reserves, many of which are in US dollars. The value of US credits and the stability of the dollar are the key issues in the world’s most important economic relationship.
–Like a loving but firm spouse, China has taken the news and issued some hard words for America. An editorial at state-media outlet Xinhua gives the following relationship advice to America’s politicians:
The US government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.
China, the largest creditor of the world’s sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets.
International supervision over the issue of US dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country. We have to recognise that the world has entered a global financial crisis that concerns all countries.
–The trouble is, there is no stable and secure global reserve currency this morning, unless you count gold. The conventional wisdom is that the world could move from a dollar standard to a “something else” standard with very little disruption. But this week will be a good test of that wisdom.
–For one, the US downgrade is going to heighten the risk for all other borrowers. It’s a little like when everyone in a row of seats is asked to move one seat over. That doesn’t mean other sovereigns will be downgraded. But it means large investors are going to be more sceptical about government, corporate, and municipal bonds.
–The lack of confidence in fixed income investments ought to reward cash. But will it reward stocks? Probably not in the short term. Stocks are pricing in much lower growth. A hybrid strategy, which we’re pursuing in Australian Wealth Gameplan, is to buy a handful of beaten-down blue chips that have high returns on capital and pay dividends.
–Of course the hope here in Australia is that China will save your super. Australian Super director Ian Silk told the Age this weekend, “While the US represents around half of the global equity market, we have a substantial allocation in emerging markets including China, where we expect stronger growth and less volatility.”
–He also said not to panic. He’s probably right about that. The time to panic was months ago, when everyone else was calm. We’d look to be buyers of both gold and value stocks, but only after this coming surge in anxiety and fear has crested.
–High tide for global fear may be today. The European Central Bank has restarted its bond-buying program. It made the announcement late Sunday night in Europe, just in time for markets here to make sense of it. The ECB will buy bonds issue by Italy and Spain, Europe’s third- and fourth-largest economies, respectively.
–What does it mean? Well, the ECB is buying Spanish and Italian bonds because it appears no one else will, not even the Chinese. But the ECB doesn’t actually have the money to meet the borrowing needs of Spain and Italy. It will have to conjure the money out of nowhere. Or it will have to borrow on the full faith and credit of the European Union.
–That’s a huge step. Up until now, the EU’s member states have all used the same money to run their own fiscal policies. If this is a centralisation of European fiscal policy, it’s kind of the natural fulfilment of the whole European experiment: everyone living at everyone else’s expense with borrowed money. No one is responsible for anything but we’re all responsible for everything.
–Philosophically, that’s absurd. Economically, it’s insane. Chronologically, it may buy Europe a bit of time before the ultimate insolvency of the Welfare State becomes obvious to everyone. Practically, that means you still have time to do something about it.
Markets and Money Australia