|Where to start on a day like today...|
Aug 9, 2011 Ben Rabidoux theeconomicanalyst.com
More thoughts on the S&P downgrade
The media is full of commentary discussing the impact of S&P's downgrading of US sovereign debt to AA+ from the coveted AAA rating, largely blaming the stock market drubbing on this event. The media doesn't get it.
After briefly falling, both the US dollar and US treasuries found sustained bids throughout the day. Treasury yields fell across the entire spectrum with the exception of the very short end, while the US dollar is now within spitting distance of breaking through parity with the Loonie.
As I said yesterday, the downgrade needs to be put in perspective. Moody's and Fitch, the other two big rating agencies, recently affirmed their AAA rating on US debt. Yet S&P considers the US to be at greater risk of defaulting on its debt than Microsoft, and on par with with the riskiness of Lichtenstein. Does anyone seriously believe this?
While fiscal discipline is needed in the US, the loss of their AAA rating while France and the UK maintained theirs seems laughable to me.
Regardless, let's remember the world we now live in. Everything is relative. And as I said yesterday, does anyone seriously believe the US will see the crap hit the fan before PIIGS woes cripples the Eurozone and threaten the survival of its common currency? In a world where all things are relative, expect capital to flee the weaker areas for the relative safety and liquidity offered by the US treasury market.
The reality is that the European Monetary Union is in a race to implement a credible solution to the debt woes in its peripheral countries before the bond market forces some form of debt restructuring. The ultimate lasting solution would be a debt consolidation and the issuance of Euro bonds....but good luck floating that past the people of the more financially stable countries like Germany. Who can blame them. Who can blame them for not wanting to assume the debt of the Greek people who have experienced years of excess spending, rampant tax fraud and, unsustainable growth in their public sector.
Yet without a credible solution, restructuring is inevitable. And with it come major losses at the big European banks, credit market tensions, and the heightened specter of a renewed credit crunch.
THIS, coupled with the significant slowing in the US and global economies, is what is driving the exodus out of risk assets and into safe havens like treasuries and precious metals.
About that global weakness...
On that topic, the Conference Board of Canada released their leading economic indicators. One word: Slowdown.
Every region surveyed was identified by the Board as either being in a 'slowdown' or as peaking.
So what comes next?
Likely a recession for the US. Fiscal policy is now firmly handcuffed while consumers are retrenching and house prices are double dipping. And us here in Canada? Well, all of a sudden that 1.5% GDP forecast I made last year doesn't seem so laughable. And with consumer confidence now firmly retrenching, as also reported by the Conference Board:
"The Index of Consumer Confidence dropped for a third straight month in July, this time falling 1.8 points to 81.3 (2002 = 100). Consumers continue to express uncertainty about future job prospects, despite strong job creation numbers so far this year. As well, the balance of opinion on the major purchases question has trended increasingly negative over the past year."
People who don't feel too rosy about their future prospects tend not to spend frivolously. In fact, they largely delay major purchases. And yet consumer spending represents 65% of our GDP. It's not shocking then that demand for consumer credit is at its weakest level in nearly two decades.
All of this is happening at a time when house prices are stable, though showing increasing signs of topping. If you want to see consumers really retrench, just throw in falling house prices which effectively cuts off wealth effect spending....as well as access to lines of credit, which I believe have masked what would otherwise be a higher default rate. No one defaults when they have access to additional credit. Pay Peter by robbing Paul. Rinse, repeat.
Yet the acceleration of mortgage debt relative to GDP (which has a very strong correlation to real house price growth) has been exceptionally weak over the past two quarters.
If I were a betting man, I would say that this looks as close to a peak in debt demand as I have seen. And with the increasing economic turmoil and falling confidence threatening to become the new drivers of mass psychology, the risk of retrenching sales and cooling credit demand over the next few quarters (all but assuring falling house prices) is very real.
Here's the message to take away: The world won't fall apart. If you've been investing for your future with an eye for the long-term, are holding an appropriate weighting of risk and safety assets in your portfolio, and are not following the crowds, the sun will rise again. If you're not sure how to build that model portfolio, read this.
The stock market is throwing many babies out with the bath water. For those patiently holding cash, there are some darlings out there well worth considering. We'll talk about them tomorrow. In the meantime, grab a Valium and chill out. Unless you're leveraged into the Vancouver or Victoria market or have partaken in the T.O. condo craze....Then it's time to panic.
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