S&P Downgrade of US Creditworthiness: Some Initial Thoughts
August 7, 2011
Don Rissmiller, Strategas – Weekly Economics Summary 7 August 2011
S&P’s logic: “On Aug. 5, 2011, Standard & Poor’s Ratings Services lowered its long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’. The outlook on the long-term rating is negative … the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”
History offers little in the way of guidance on this issue, but it seems clear that if we were on a local train toward Financial Repression in the U.S., we just switched to the express.
Financial repression essentially means the government taking steps to control real interest rates, either through direct intervention in banks (or bank regulation), or more subtle means (e.g., inflation).
The Obama administration believes the S&P decision was wrong: “This is a facts-be-damned decision. Their analysis was way off, but they wouldn’t budge,” CNN noted. S&P acknowledged some differences in the numeric calculations, but said they really didn’t matter.
The government has to fund itself through taxes. It can tax income (what the economy generates this period), it can tax wealth (what the economy has generated from year 0 to this period) or it can tax transactions between the two (sales taxes, Tobin taxes, etc). Financial repression is a form of tax on wealth, i.e., not letting savers earn a “normal” risk free rate of return.
We thank Don Rissmiller for permission to publish his opening discussion. He identified the issues well.
We would like to include some additional thoughts:
• Markets will reflect consensus views. We expect the following characteristics:
1. Huge volatilities in all markets are in order. Look for them.
2. Global companies can climb above sovereign debt issues. We expect large-cap stocks to do well in many countries. They are able to reallocate their resources in various places in the world. They are able to manage their currency exposures. They are not above the fray involving sovereign debt issues in their host governments, but they are able to manage that process.
• Foreign exchange markets have to face relative value choices. Which currency reflects a better outcome? Dollar? Yen? Euro? Pound? Others? Watch for volatilities in foreign exchange markets and early signs of trend changes.
• What about the reserve currency status of the United States and the US dollar? We are down to about a 60% of world reserve position. That used to be in the 70s a decade ago. We have allowed it to erode because of our policies. There is a point at which a threshold is reached and a downward accelerator works to our detriment. We do not think we are there yet, but we are much closer. Thank you, Democrats, Republicans, Congressmen, Senators, President and Vice-President. You have the long-term stake of the US dollar and the United States in your hands.
• Bonds. We have had a huge bond market rally in Treasury debt; much of it was short covering because of the debt ceiling debate. Now, it is influenced by the downgrade of credit. We do not expect much action quickly. This may mean only a few basis points in intermediate-term Treasury note interest rates. Short-term money market rates will not be impacted at all. The Federal Reserve has issued clarity on the result of the S&P action, and we do not expect much impact in the short end of the yield curve. Look for spreads on TIPS, inflation indices, and other intermediate and longer-term measures to determine bond market impacts.
• Watch the European Central Bank and what it does. Watch the Bank of Japan and Bank of England, too. Go by what they do, not what they say. The Federal Reserve is trying to say clearly what it does or means to do. Words in speeches, prepared statements help but actions mean the most. Remember that central bankers must use words to calm things down, but it takes transactional deeds to make things work. The zero bound in interest rates will be with us for a prolonged “extended period.”
We expect strong volatility, much rhetoric and media discussion in the coming week.
The midnight oil burned at Leen’s Lodge. Never could you expect to have such an assemblage of financial market professionals and economists, along with media and other observers in intense conversation over the events of the past several weeks. It has been quite a weekend.
David R. Kotok, Chairman and Chief Investment Officer