US Long Term Outlook Downgraded

U.S. stock indexes fell sharply Monday after Standard & Poor’s revised its long-term outlook on the U.S. to negative from stable. “Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating,” the ratings agency said in a release.

The rating agency effectively gave Washington a two-year deadline to enact meaningful change, just days after House Budget Committee Chairman Paul Ryan and President Barack Obama each outlined their plans for slashing debt. S&P nonetheless kept its best rating, AAA, on the U.S.

Relative to Triple-A-rated peers, the U.S. has very large budget deficits and rising government indebtedness, and the path to addressing those issues is unclear, S&P analysts said.

My View: Well, isn't this common investing knowledge? The very same people who rated those subprime loans as AAA right up to when they collapsed, are now being seen as smart experts? I am not debating whether the ratings agencies are correct, and in this case they are. Surely this should not surprise anyone. To be fair, the US markets have to weaken in sympathy with the news even though everybody knows that to be the case.

To me, it should be seen in a positive light. China and Japan are not going to sell Treasuries, even though as an investment pro they should, but they have a lot more to lose by doing that. The ratings downgrade basically gives the US government a fixed 2 year deadline to come up with something instead of just printing and warbling some more. This will give Obama more ammunition to push through tough policy choices.



The writing was on the wall weeks ago when Bill Gross of Pimco dumped all Treasuries from its portfolio. Mind you, Pimco is the world's largest bond fund as well. Pimco has moved their assets to non-US debt, real estate and commodities.

Next was Loomis Sayles, manager of the $19.9bn bond fund, they have moved from Treasuries to high yield bonds (corporate convertibles more likely to be the case). Black Rock, another mega fund manager, has shifted to shorter term Treasuries. Even Warren Buffett has shifted his portfolio at Berkshire Hathaway, for securities maturing in less than a year from 16% of total portfolio to 23%.

What they are all doing is getting out of most Treasuries, especially the longer dated ones. This is in anticipation of a massive climb in interest rates for longer term Treasuries in the coming months and years. This implies that the US will find few takers the next few times they try to sell their long bonds to raise funds, thus forcing them to hike the interest rates for them to find takers.

That means the US dollar will be on a downtrend for the longest time and will not find takers of US denominated debts unless the interest rates are more appealing. This is also good as it forces them to come to terms with their deficits and reckless quantitative easings.

How will it affect stocks? Well, US stocks will have a kneejerk reaction but not much. The indebtedness is largely on the government side and not from the corporate side. Technically, the dollar will weaken which will be better for most US products and services.

Now, this will have a massive potential effect on the HKD peg. Its pointless to say that almost everyone is in agreement that the HKD is undervalued enormously. If the value of USD drops significantly and persistently over a long period, the HKMA may be able to brush it off. But when US rates start to rise appreciably, thus importing inflation significantly into HK's economy, something's gotta give. The longer HKMA does nothing, the more hot money will pour into HK in anticipation of an appreciation to the peg or free floating it (possibly a 10%-15% increase if they were to float the HKD now, the longer it goes on, the higher the quantum and hence the pressures).

The ratings downgrade will be good for emerging markets, well good in the shorter term (6-12 months), but bad as it will exacerbate the already excessive liquidity in many emerging markets. We should see a continued surge in US funds getting more exposure into non-US securities in the coming weeks and months.



Thankfully, the USD is not as important as it was to most Asian economies as it was maybe 10-20 years ago. More importantly for us, its the Chinese yuan. Thankfully again, most emerging markets are doing more business with each other and not just Europe or the US. Hence the macro calamities in Europe and the US would mean more funds moving to "performing emerging markets". That said, emerging markets will now have to deal more effectively with hot money and excessive liquidity running up assets of all kinds.