The Risks of a Downgrade

In the month of August 2011, America lost its pristine AAA credit rating. The ratings agency Standard and Poor`s downgraded the U.S. credit rating from AAA status to an AA+ rating, marking the first instance when the U.S. has not held the highest possible rating since 1941.

S&P said in its statement:

"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government`s medium-term debt dynamics. The outlook on the new U.S. credit rating is "negative," indicating another downgrade was possible in the next 12 to 18 months."

This move is likely to raise borrowing costs for the American government, its companies and consumers. The downgrade in the ratings did not come as a surprise to most experts and market watchers who monitor structural trends. The current economic problems can be boiled down to one issue: too much debt.

The graph below indicates that the U.S.`s debt levels have increased over the last few years to unsustainable levels. The national (public) debt in the U.S. has grown to $14.587 trillion, and is growing at a rate of $4.02 billion per day.

Source: Bloomberg

Another disturbing fact is that U.S.`s total (Federal, State and Consumer) debt outstanding at the end of 2010 was estimated to be $52 trillion! However, it is to be known that the debt of the U.S. is growing faster than its economy. Between 2001 and 2010, the total debt grew from $28 trillion to $52 trillion. During the same period, the GDP only increased from $10 trillion to $14 trillion. So, while the debt grew by $24 trillion, the economic growth increased only by $4 trillion. We can easily say that, to produce $1 of economic growth it takes $6 of debt, making it clearly unsteady.

As shocking as these debt figures appear, they do not include future unfunded entitlement liabilities, which are estimated to be another $60 trillion as of 2010!

It should be understood by now, that the U.S. deficits and debt levels are unsustainable. The important question right now is what the next policy response will look like. Given a slowdown in the U.S. economy and the risk of another recession, the growing risk of debt spreading in Europe, and a slowing Chinese economy, a coordinated policy response on a global scale cannot be out of question. The Fed and other central banks around the world may have to act in sync to lift depressed sentiments and raise asset prices. Any such attempt is likely to lift asset prices, leading to inflationary pressures which would bring another surge in precious metals especially gold.

Repercussions of the S&P announcement:

The announcement in itself may not have any immense effects. The downgrade of the U.S. credit rating would have eventually happened, but now that someone has finally been vocal about the issues, it serves as a wake up call for financial markets who are realizing that "Risk-free" was always a ruse. But now, treasury bonds have become risk-certain and those who believed in risk-free markets will find out that it is indeed risky.

The real downgrade would be when the bondholders start pricing in the risk and this leads to increase in borrowing cost in the long run. Credit agency ratings are important because their ratings are placed highly in the financial system by regulators and governments. However, while they may be important in the short run, it is the markets` own ratings that will matter during the long run. Markets will perform their own credit analysis of countries and will do their own debt downgrading, i.e. they will demand higher interest rates. The Japanese debt was downgraded to AA- in January 2011, but this action was a nonevent. Despite being the most indebted developed nation, Japan is still borrowing at the same pre-downgrade rates, which are half of the rates the U.S. government pays on its debt. On the other hand, Italy`s 10-year bond rates jumped to 6% without any downgrade by credit agencies; the markets did their own credit analysis.

Keeping the traditional outlook in mind, there is almost a zero chance of the U.S. defaulting on its debt. All their debt is in US dollars, and they can easily print their currencies at will and in as much quantity as desired. Hence, they will not go through the traditional default path, but will probably default due to the inflationary method by printing money. The US government will honor its obligations in nominal terms, while defaulting on its debt in real terms.

The problem:

Sovereign debt issues have risen to the surface, and it is making the current financial situation precarious. There seems to be a growing belief that the economy may be heading back into recession again and the U.S. government`s apparent ineffectiveness in preventing such thoughts from occurring, is adding to the concerns. Quantitative Easing, QE1 was done to solve the liquidity problem, while QE2 was undertaken to stimulate growth in the economy and bring down the unemployment rate. Now, we can see that such financial stimulus is winding down and QE2 also ended in June 2011. The markets now seem to be questioning the outcome of such measures. While it can be seen that unemployment is rising, economic growth remains weak and is at risk of another recession.

The U.S. government`s intrusion into the economy and the markets has made things worse and the economic statistics only affirm it. At the end of the fiscal year 2008, U.S. debt stood at $9.986 trillion, and currently, it stands at $14.587 trillion while the unemployment rate stands at 9.1%. Despite over $4.6 trillion in new debt, and a $2 trillion expansion in the Fed`s balance sheet, unemployment rose by close to 2% and economic growth fell to less than1%. To add to the damage, the stock market tracked below the levels set at the commencement of QE2. All we have to show for the government`s intrusion is a higher inflation rate.

Such statistics just prove that what used to work before is not working anymore. Even worse, the policymakers have kept suggesting the same tactics expecting different results each time they are applied.

The result of such policies is that the debt imbalances keep growing and are clearly on an unsustainable path. The 2007–2008 financial crisis is just a glimpse of what lies ahead, and there is a possibility of a much bigger economic storm hitting us.

The current situation:

The main cause of all the current economic challenges; unemployment, housing issues, sovereign debt crises etc, is that our policy makers have repeatedly opted for easy fiscal methods to solve the problems at hand instead of addressing them head-on.

If you carefully analyze the resolve to the debt ceiling quandary, there still exists the tendency to kick the can down the road until after the next presidential election, when unfortunately (or hopefully fortunately) the hard choices will be forced on the next administration.

It also seems that no constructive decisions are being taken on those debts and instead, the government is trying to hold up bad debt with public funds and monetary policies which are aimed at distorting the financial markets even further.

Consumer spending has become stagnant because of the high unemployment as well as the debt burdens on the public. Also, businesses are not too keen on hiring as they do not see any prospective demand in the future. Hence, policymakers need to understand that the problems of unemployment can only be solved once they address the debt issues directly.

The reason that policy makers have protected bondholders is because of the constant fear of a financial collapse if bondholders suffer any loss. The stock market has just lost about $1.5 trillion in market capitalization and such a financial system is still functional. The real issues lie in the vested interest of the powerful financial companies and not the public. This proves that there is a strong need to depoliticize money.

The market reaction:

Gold opened up by $30 on Monday morning and went all the way to set record highs above $1800 - leaping forward by almost 9% in just a week`s time. However, the parabolic escalation and increased volatility off late makes us cautious. At the same time, we believe that not much has changed fundamentally for gold; instead the ongoing uncertainty has rather intensified the command of gold. However, by most measures gold still continues to be significantly under owned. Some major reasons that would drive gold prices are negative real interest rates, issues surrounding currency debasement, rising inflationary fears and diversification of investments and reserves to gold.

The U.S. credit downgrade has sent reverberations throughout the entire world`s financial system. But nothing has changed fundamentally. The U.S. government has been broke for a while, and the U.S. dollar has been headed towards worthlessness since 1971. But, since someone from within the financial structure stated the facts, that maybe everything isn`t as it seems, it shocked the world.

Unless the policymakers bring some changes in the way of additional stimulus or in the form of a QE3, the U.S. economy is likely to weaken further as deleveraging takes its toll and the unemployment rate to continue to rise. Further downgrades of the U.S. treasury debt are also unlikely. Gold`s performance over the past decade has been consistent and clear, and has shown long-term uptrend which no signs of weakening.

By all measures, the U.S. economy is being weighed down by a veritable mountain of debt and the foundation for the next self-sustaining, structural growth cycle cannot be created until the deleveraging process has run its course. Unfortunately, there are no easy solutions for a crisis that has developed over the past three decades, and the economy`s performance will continue to suffer until the debt issue is addressed in a comprehensive manner.

Note: The source for the above data / information is Bloomberg, Mybudget360.com and Alternativeinsight.com

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.