The Standard and Poor’s (S&P) downgrade of long-term U.S. debt from AAA to AA+ is sad, but it is not news. Everyone already knew we were in trouble and to act surprised is unjustified.
Now we and our politicians can no longer deny it. It’s official, which may be good for us long-term. While the timing is poor, because of the delicate nature of the entire global economy, this action will be the catalyst that forces our government officials to put a plan of deficit reduction and debt elimination in place.
In my last article on this subject, “A Goal in Search of Leadership,” July 28, 2011, I was critical of our politicians for not demonstrating leadership. I’m talking about establishing a bold vision – putting a man on the moon before the turn of the decade, type of vision. I have not heard anyone important in government say, “We will eliminate the U.S. debt and properly fund our social security and health care programs by the year 2021. Here is the plan that will allow us to do that. We need everyone in our great nation to help us get there. Let’s show the world we are not a bunch of deadbeats”.
We all know what the dangers are for us to continue on this path, even with the bill President Obama signed into law last week. That bill fell short of addressing the increasing deficit and debt.
The Budget Control Act’s $2.4 trillion in proposed cuts would phase in slowly over 10 years allowing debt as a share of GDP to reach 91% by 2021.
The chart below is from this week’s Barron’s Magazine that shows the problem more clearly:
As you can see from the chart, without this bill we would be at 101% of GDP, with this bill we will be at 91% of debt to GDP. This bill has no teeth over the next 10 years. We can’t let ourselves get anywhere near 90%.
According to studies of failed nations by Carmen M. Reinhart, Economics Professor at the University of Maryland and Kenneth S. Rogoff, Public Policy and Economics Professor at Harvard University, when a country reaches 90% of sovereign debt to GDP it loses an additional 1% of GDP. Think of this as the stall speed for an airplane. If we are in a 1% to 2% slow growth environment now, we can’t afford to lower the speed that keeps the plane aloft. It’s the point of no return. The debt and the interest on the debt will continue to rise.
Impact on the Markets
Expect the markets to remain volatile between now and the 2012 election. The politicians will kick the can down the road until then. Over the next few weeks, there will be plenty of talk about the impact of the S&P downgrade of our long term debt. Clearly it’s not positive, but I don’t buy into the catastrophic talk.
Many insurance, trust companies, money market funds and municipalities (Muni Bond Issuers) will have to review their contracts and trust documents to see exactly how they are worded as far as the quality of the bonds they are required to hold. They will either have to do nothing or replace some of their holdings with higher AAA rated securities. Until this legal review is completed, there is no way of assessing the impact of the downgrade on the markets.
Several countries (those that can control their own currencies) have had their sovereign debt downgraded and the impact has been very minor. However, the U.S. Dollar remains the world’s reserve currency, as such the entire world is watching. Let’s be clear about one thing, the U.S. cannot default as long as it is able to print its currency and as long as congress and the President allows the debt ceiling to rise; so the probability of near-term default is zero.
As you know we have been positioning our portfolios, and remain positioned for a very slow growth economy. While our portfolios lost ground last week, we were not nearly as damaged as the S&P 500 index. That’s because we have many defensive managers and funds in our globally allocated and highly diversified portfolios. While some of our funds can short the market, potentially profiting from falling stock prices, one of our major holdings PIMCO All Asset All Authority was short the market well in advance of last week’s downturn providing some hedging affect to the overall portfolio.
While the stock market will react to this announcement, in my opinion it is more about the European debt and monetary crisis dragging the rest of the global economy into another recession and not the S&P downgrade. While anything is possible, keep in mind that recessions do come and go and they last an average of 12 to 18 months. We have been through this before and we will navigate our way through this again, based on evidence and data, not on emotion and speculation.