Research & Insights

Special Market Comment: Relatives and Absolutes

August 8, 2011

By Katrina Lamb, CFA

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A great deal has been said over the last three days about the S&P downgrade of US government debt. Much of this chatter has been wearily familiar as the usual actors who reside in Versailles-on-the-Potomac  recite from the predictable scripts of blame and false sanctimony. Let’s get straight to the point: how is the world different today, and how is it not different?

How it’s not different: The US has not ceased to be a safe haven. Look at the evidence – stock markets are plunging while, true to form, yields on US Treasuries are lower than they were last week. Remember – yields fall when prices rise. In fact the 10-year Treasury is right now flirting with a yield of 2.3%, which is a low of historical magnitude. The plain fact is that there is a global glut of savings that has to park itself somewhere. US corporate balance sheets are swelled with over $1 trillion in cash, and at any given time a good chunk of that cash will be invested in some mix of US government debt, downgrade or not.

How it’s partially different: There are other assets performing the safe haven role along with Treasuries: gold is up $40 today, and both the Swiss franc and the Japanese yen have resisted concerted policymakers’ efforts to keep the exchange rate down. As we noted in a recent column (Safe Haven Economics 3.0) the notion of safe haven asset itself is changing with the times. Relatively speaking there is no natural successor to US government debt as the go-to risk free asset. Rather than the idea of one “risk free asset” we should start thinking along the lines of “low risk basket” as a valuation benchmark.

Which brings us to how it is different: The absolute level of risk is higher now. Whether one agrees or disagrees with S&P’s decision (and fans of the rating agency appear to be few and far between) it is meaningful in a long-term sense that the bellwether asset of the last sixty years of global economic history is no longer triple-A. Not because the US can’t pay its bills – it can, simply by printing more money as Alan Greenspan himself blurted out on one of the Sunday talk shows – but because the pillars of the global economy – the US, Western Europe and Japan – are not as solid as they once were.

With the downgrade behind us attention will once again shift back to Europe. “Italy and Spain are the new Bear and Lehman” goes one pessimistic point of view. Actually they are not, for a number of reasons. Italy is not bankrupt – in fact it has a very high rate of domestic savings and its national fiscal budget is in primary surplus (i.e. before including interest obligations). Spain’s debt-to-GDP ratio is just over 60%, a far cry from the 140% ratio of Greece. In 2008 we were looking at the very real possibility that the banking system itself would simply stop working – payroll systems would stop direct depositing wages into checking accounts and ATMs would run out of cash. We are not looking at that specter – not today at any rate. There is a crisis of confidence in European bond markets, and that has long-term implications for the EU and the viability of the Euro. But what we expect to be more likely in the short term is ongoing volatility with a number of variables that could send markets higher or lower on any given day. Trying to guess which variables will show up on which day would be a fool’s errand indeed.


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