US Debt Downgrade – just another phase of the GFC.

In February 2009 after I came back from holidays in Yamba I sat down with a mentor and mapped out how we thought the crisis would manifest over the coming years. I had a massive advantage over many investors and traders in that in my research I had stumbled upon a book written in 1996 by a Historian named David Hackett-Fischer. Professor Hackett-Fischer had written a history of inflation going back to the 1200’s, but in doing so he had mapped the economic history of the globe during that period. When reading that book, sitting on the couch after surfing Angourie, I was struck not that this book, “The Great Wave: Price Revolutions and the Rhythm of History” was about inflation but rather that it was a rolling history of the crises of the western world over the past 800 years and that this crisis we were in was probably going to be long lasting and that it would have several phases.

So back in my old office on the second floor Steve and I mapped out how we thought things would go.

  • First stage was what we had already seen, Government rescue;
  • Second stage was bounce After the government rescue;
  • Third stage was recognition that the bounce wouldn’t be followed up and that Government finances were now in trouble;
  • Fourth stage was recognition of this fact and the imploding of belief that Governments of the world could actually save the world and back down we would go.
  • Fifth stage was then the cleanup, which could take years.

Our view was that the world would lack aggregate demand and probably go through a period of deflation and that ultimately, some way down the road between 5 and 15 years, inflation would come back with a vengeance.

Implicit in this discussion was that the United States would not escape unscathed from the carnage.

In truth we were wrong, we expected all that has happened since April this year to happen in the last quarter of 2010 but we did expect it to happen, nonetheless.

Why have I spent so much time saying all of this when I guess you want to know what we think will happen as a result of the US credit rating downgrade? Because this was always going to happen, so it is important to have a historical perspective and as David Hackett-Fischer told me, not to panic, because we will get through this. In the mean time markets are likely to be in a funk for a while and capital protection is paramount, the world economy has to heal. That is the process.

So what does it mean for markets?

I’ve already posted my thoughts on FX  this morning and the summary would be that we are in a phase transition to a world where the USD is no longer holds the reserve status that it once did, but a world in which the alternatives aren’t available or obvious at the moment. The AUD is just going to be buffeted in the backwash and likely more impacted by what happens to global growth.

For US Treasuries it is probably less important than the impact of the economy on yields. Sure for any given level of economic strength or weakness Treasuries may trade a few points higher than they might have a few days ago the reality is that even though perceptions are changing about the credit worthiness of Uncle Sam questions about other AAA rated entities such as France must be asked AND answered. My sense is that the economic weakness predominates and long-term yields head toward Japan like levels in the year/years ahead.

Equally the economic weakness globally will likely undermine commodity prices at a time of weak aggregate demand and so take away inflationary pressure, the deflationary phase we were looking for. this means the term structure of western world interest rates is likely going to be lower for longer than many traders and investors anticipate.

For equity markets it is going to be about the trade of between consumption of their goods, productivity improvements and the ability to generate returns that justify what are still heady prices on a forward outlook for growth and consumption. My gut feel is that we are in for further consolidation in prices over the medium term even if we get QE3 up and running in the US once again. Two strike at this havent worked for the economy, I doubt the third will be anything other than out. It might however generate some trading opportunities.

For us here in Australia it means the RBA is going to struggle to find the catalyst for an interest rate increase. Our economic growth will struggle to be maintained against a weakening global backdrop and consumers and households can’t fail to see the implications of all of this for their personal position which means further retrenchment. But the good news in that is that we are rebuilding our balance sheets which is helpful for the future.

Overall in my view the S&P downgrade of Uncle Sam reflects a reality that was already in train. For many it is a wake up call and markets will be under pressure once again. I am hopeful that this also ushers us into the clean-up and healing phase for the global economy.

Indeed I’m sure it will, it’s just a question of how bad it gets first. Circumspection and capital protection remains our overriding mantra.

For further really good analysis on what this means can I recommend you visit my colleagues over at http://macrobusiness.com.au there are some cracking articles we wrote overnight.

greg@lighthousesecurities.com.au

www.twitter.com/gregorymckenna

This blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

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One Comment on “US Debt Downgrade – just another phase of the GFC.”

  1. tristencosgrove Says:

    Great post Greg. I too see it as a continuation of the GFC. I have been waiting for a general realisation that Government’s alone cannot “save” us and we are “own our own” to a certain extent with another associated general panic. After that though, people will survive and find they can keep going on their own and rebuild from there.

    Reply

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