The Downgrade Parade Continues

Location Date: 
August 8, 2011

Well that did not take long! As people in the Arrow office know well by now, whenever I take a holiday in Euroland, the proverbial *&%^ hits the fan in the markets. Last year, I was in France for the "flash crash" and this year I get the S&P downgrade and a mini quasi-crash in the markets! While on my honeymoon in 1991 when I was at BPI, we enjoyed the Yeltsin overthrow of Gorbachev in Russia and numerous other "events". Oh well - I will give everyone fair warning next time so you can position yourself for another round of high spurious correlation! 

So S&P has downgraded U.S. debt from AAA to AA+. This is likely more of a psychological hit to U.S. confidence than anything "real" per se. It certainly took guts for S&P to part company with the other rating agencies especially given their role in the mortgage debt fiasco - I am not sure I would want to be a shareholder in McGraw-Hill these days. The U.S. can clearly pay its bills but the lack of leadership and a politically challenging structure make the long-term debt picture slightly problematic. But for France to have a higher credit rating than the U.S. - mon dieu, c'est incroyable. We believe that any weakness in UST pricing will be a buying opportunity. As S&P did not downgrade short-term USTs, there are no issues with respect to the banking sector taking any "haircuts" on their substantial UST exposure. The next "big" event for the US is the upcoming Jackson Hole speech by Mr. Bernanke - we doubt that QE3 is up next, but it is quite possible that kind of an "Operation Twist" is possible affecting rate level maximums, so stay tuned. 

The truly big issue is Europe, not the U.S. As a recent Der Spiegel headline stated, "Is the World Going Bankrupt?" Well, no - but parts of it are, those being Greece & Co. I have been harping on the European issue and will do so again because it is the epicentre of the crisis - how fortunate to be travelling in Italy where I can watch Berlusconi e Co. in action daily. The ECB announced Friday evening that they were prepared to purchase Italian and Spanish debt; how much and when are still a mystery, as was the ECB press conference last week - talk about Bizarro World. If that was Mr. Trichet's idea of a clear signal of support then the fireworks will get much worse in Europe. Perhaps it is the fact that the ECB really has no money - save for dipping into the Bundesbank cookie jar - and that may take some cajoling. The EFSF, which is currently capped at €440 billion, will need to be expanded materially to cover off Italian and Spanish exposure (of course at the expense of the implied much higher debt-to-GDP ratios for France and Germany). One small issue is that everyone is on holidays here in the month of August so it will be difficult to get all the various parliaments to reconvene to ratify such a move. The analysts at Stratfor suggest that Germany has "definitely decided that it will allow its wealth to underwrite the union, but only for political control over how its wealth is used". While that may be true, I am not sure anyone has bothered to ask the thrifty German citizens if it is ok or not. This is either a precursor to a true "Euroland Bond" or the unraveling of the euro - it is hard to see a middle ground just yet.

Outside of Europe, the main issue is global growth - or the lack thereof. The shock of the GDP downward revisions and further weakness in PMIs globally have equity markets searching for appropriate levels at which to stabilize. The big declines in cyclicals and economically sensitive stocks and commodities show that we are making progress towards that reset, but it is extremely hard to say if we will have some growth or slip back into a recession. Extrapolating the fiscal situation is tough (will the U.S. alter its debt reduction course post-S&P? Will the wrangling over it lead to even more divisive political behavior?) and overlaid with a deleveraging U.S. consumer and a nervous corporate market (although cash-rich), you have the recipe for continued uncertainty and volatility. As such, owning protection in the form of high-quality fixed income and being long volatility or hedged from an equity standpoint makes a great deal of sense right now. Cash, the much maligned asset which pays you zero right now, is also good to have to take advantage of opportunities that will present themselves. Given the speed at which markets move these days, these opportunities may be close at hand.

Jim McGovern

P.S. Thank you to all the well-wishers for the U15 Canadian Synchronized Swim Team - they won the bronze medal placing third behind the Russians who were sensational and the Italians who had the home crowd advantage - well done girls!!