Undoubtedly, everyone caught up in the financial crises of late spotted this headline online or in their local paper or on a television news program recently:
US Warned on Debt Load: S&P Signals Top Credit Rating Is in Danger
If that doesn’t catch your attention, then few things will. Okay, fair point, the U.S. debt now stands at $14.2 trillion dollars (that’s trillion with a “t”) and is expected to increase with the rising costs of the entitlement programs such as Social Security and Medicare. So maybe the headline might not be so shocking. And, indeed, the news is disconcerting, but in our opinion very overblown. Here are some things to think about:
Where else are you going to go?: As noted in the chart below, the United States is one of several AAA-rated countries. Investors could possibly move their funds to some of these other countries, but notice the value of goods and services each country produces (GDP). The U.S. numbers exceed every one of the countries by a significant amount; in fact, you would have to combine the GDPs of all of the other AAA-rated countries to match it. This is good because it means we have the largest economy in the world.
Remember Japan: This is not an actual downgrade, but the United States’ rating is under a warning/credit watch. Yes, once this warning occurs, there is a 1-in-3 chance of an actual downgrade, but look no further than Japan to see the consequences. In 1998, Moody’s downgraded Japan’s credit rating, and S&P followed in 2001. Despite this, Japan still borrows at 1.3 percent on their 10-year bonds. This is a very low borrowing rate, and our economy is much more stable than Japan’s was back then and today.
The bond market did not react: Typically, when a credit watch is issued, bond investors start selling off that country’s bonds, and their yields increase significantly. (In plain English: The lenders charge them more to borrow.) However, U.S. treasuries increased in value the day the warning was issued and the yields dropped, which means the U.S. borrowing rate actually went down, not up. This is very telling, since bond investors tend to be the ones to sound the bugle when danger is coming.
This is an easy fix: Our budget and debt situation can be fixed pretty quickly with some small changes to multiple government programs. For instance, we could change the Social Security retirement age to 70 instead of 67 for the younger generation, and then the fund would stay solvent for a long time. The same goes for Medicare.
It will be worked out: This is a negotiation among Democrats and Republicans. In any negotiation, you stand your ground as long as possible until the other side gives into your demand. However, when you get down to the wire, and no one is budging, the parties eventually begin to compromise. This is what‘s happening in Washington, so I would expect something significant to happen later this year. They all agree the deficit needs to be reduced, but they cannot agree on how to get there. It will come.
Moody’s has the opposite opinion: S&P’s biggest competitor, Moody’s, has the opposite opinion of S&P. They feel, as we do, that things look positive with the budget negotiations going on in Washington right now.
China would have to sell off U.S. bonds: About half of all U.S. Treasury bonds are held by foreign investors. China is the largest investor by far (around $1.2 trillion) and has no intention or incentive to sell U.S. Treasury bonds. They are happy to lend to the United States as long as we keep our strong business relationship intact. It’s a key point and is the reason why the market keeps a close eye on China’s appetite for U.S. bonds.
In short: Don’t bet against the U.S. Keep in mind; the United States has a massive economy with stable, transparent institutions, a dominant reserve currency and an entrepreneurial spirit like no other.
Regardless of what happens, here at Redwood our 5,000 bonds that make up the fixed income portion of our portfolio consist of a good mix of U.S. Treasuries, foreign bonds and corporate bonds. In addition, our stock portfolio consists of 10,000 companies, 40% of which are companies located in countries outside the US.
We still stand by the strategy we adopted at the beginning of this year: Favoring U.S. and international blue-chip large companies and maintaining our investments in short-term high quality bonds for the rest of this year.
By Lane Steinberger