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8 August 2011
The Real Worry is Growth, Not U.S. Debt
Standard & Poor's did global policy-makers a huge favor by downgrading the credit rating of the United States from the previously perfect triple-A rating by diverting the attention of the markets and the public from the truly crucial matters besetting the global economy.
Obscured by the all-S&P-downgrade, all-the-time coverage was the agreement by the European Central Bank to purchase bonds of the eurozone while the Group of Seven pledged to maintain financially stability.
Even if there was no hyperventilation over S&P's downgrade, markets would likely continue their slide, as their performance last week showed. The markets' decline actually accelerated on the downside last week after the U.S. hammered out an 11th-hour agreement to raise the debt ceiling and stave off a self-inflicted default.
That strongly suggests the problem besetting the markets and the economy lie elsewhere.
Consider that the European authorities are cobbling together a scheme to allow the third-largest economy in the euro zone to be able to continue to roll over its debts — an ability that proved far from certain as the experience of Greece, Ireland and Portugal have shown. Moreover, the yields on the benchmark 10-year bonds of the governments of Italy and Spain have risen sharply, to over 6%. That may not seem like much, but given their debt burdens — and their need to roll over maturing debt — it is formidable since the debt burden compounds rapidly at higher interest rates. This, importantly, was the breaking point for Greece.
Consider again the experience of the U.S. Throughout the dysfunctional dialectic that gripped the two parties over the debt ceiling, the yield on U.S. continued to fall. Indeed, two-year notes at one point traded at 0.25%, which means that an investment of $1,000 over the term of those securities would have given the holder all of $50 of income.
This raises the question of the whereabouts of the so-called bond vigilantes. These are the investors who effectively enforced the need for the U.S. government to put its economic house in order a generation ago. They did so by sending Treasury note yields to the mid-teens and by pushing long-term bond returns to 15%. Those yields vastly exceeded the historical returns from risky equities and allowed investors to lock in yields that permitted them to double their money in about five years.
By contrast, investors rushed to purchase 10-year U.S. Treasury notes yielding under 2.5% and 30-year bonds yielding less than 4%. The question remains, why do global investors want U.S. government obligations at such low yields and shun those of governments in the euro zone that are more than twice as high?
The fact remains, even after S&P's actions, the U.S. government may be the world's largest debtor, but its liabilities still are the safest assets in the world. The U.S. economy is the world's largest. America remains the preeminent superpower. And the U.S. issues debt in its own currency, the dollar, which remains the world's reserve currency.
And one cannot overlook the visual acuity of the ratings agencies in the past. The three blind mice, aka the major ratings agencies, saw fit to award triple-A ratings to mortgage-backed securities collateralized with subprime loans. S&P, for its part, rated Enron and Worldcom as investment-grade credits mere weeks before they filed for bankruptcy. It is not for nothing that credit ratings are considered a lagging indicator.
Now, triple-A ratings continue to be accorded to Germany and France, both of which will find themselves increasingly on the hook for the debts of their weaker eurozone brethren. The U.K. brags that its austerity measures are maintaining its triple-A rating, a brave defense of its deflationary policies that recall that of then-Chancellor of the Exchequer Winston Churchill to restore sterling's pre-World War I parities in the 1920s.
America's downgrade by a single ratings agency obscures the real problems now besetting the global economy. Instead of being solved by steps taken over the past year, the European debt crisis is getting worse. The slowdown in the U.S. economy is not a transitory phenomenon caused by exogenous shocks such as the tragedy of Japan's earthquake and tsunami. China, meanwhile, is not experiencing simply a benign pause in its growth but something more serious, as the need to deal with its local debt, which at $1.7 trillion equals 27% of that nation's 2010 gross domestic product.
Arguably, the U.S. debt situation, as ominous as it may be in the long term, is perhaps the least of the clear-and-present problems besetting the world's economy. That is not to say that no problems exist; exactly the opposite.
The media is obsessing over the actions of what may prove to be the Meredith Whitney of ratings agencies. (You remember her, the errant prognosticator who predicted municipal-bond defaults in the hundreds of billions of dollars in 2011.)
The bond vigilantes think otherwise. Ten-year Treasury yields hover just over 2½%, at 2.56%, little changed following the downgrade. That strongly suggests that the U.S. debt situation, parlous as it may be, is not the problem. Thus, the solution would lie elsewhere.
The misperception that results has an important implication for investors: By any measure, the valuations of world-class U.S. equities are too low and their returns based on their here-and-now cash flows exceed virtually any alternative.
Back in the 1970s, when the Death of Equities was declared and top-quality U.S. stocks sold for similar valuations, the competition was formidable in the form of double-digit bond yields. Now, bonds hover near record lows while the earnings yields on stocks (the reciprocal of price-earnings multiples) are near historic highs.
There are important challenges for the finances of over-indebted governments. The greatest of those is continued sluggish growth because of the debt hangover from the previous binge. That same uncertainty is making equities a less risky long-run alternative to low-yielding government securities that one day may be vulnerable to the decision of a ratings agency.
In the meantime, the greatest risk is posed by slowing growth. The ability of the U.S. to service its debts should be the least of your worries.
