Yesterday’s Syntrinsic Commentary spoke to the larger implications of an unsustainable approach to capitalism, specifically, capitalism that requires inexhaustible credit to function.
Today, as you may know, Standard & Poor downgraded the United States debt rating from AAA to AA+ with a “negative outlook,” meaning that they expect future downgrades. Let us share a few thoughts on this action, what it means and doesn’t mean, and at least some the implications.
Who is Standard & Poor?
S&P is one of the three major rating agencies charged with providing credit ratings to companies and governments. It is a for-profit entity, like the others. It is hired and paid by the issuers it rates. The other two major rating agencies are Moody’s and Fitch.
Was this downgrade predictable?
Yes. But first, we think it bizarre that so much credence continues to be assigned to credit rating agencies that very recently assigned AAA ratings to subprime and Alt-A mortgage backed securities, auction rate securities, and other asset back issues that they did not understand and did not act particularly interested in understanding. The credit rating agencies have not yet meaningfully changed their outlook on the municipal bond market, a market that is just screaming to have its risk profile reassessed. Clearly, when one is in a “pay-to-play” relationship with issuers, one’s judgment gets cloudy.
Given that lack of rating-agency creditability, we think it is far more important to look to the markets as a barometer of the risk of a security. As far back as March 2010, corporations such as Proctor & Gamble (AA- at the time), Berkshire Hathaway (AA+), Johnson & Johnson, and even Lowes were paying lenders less than the US Treasury, implying that they were perceived by the markets as less risky than loaning to the US government. At that time, Moody’s reported that the US was at risk of losing its AAA rating, and that was well before health care reform was adopted, 8-9% unemployment proved unexpectedly persistent, and the debt ceiling required a $2.1 Trillion or 15% increase. (See: “Obama Pays More than Buffett as US Risks AAA Rating,” Bloomberg, March 22, 2010).
In short, this downgrade has been coming for a very long time, was well telegraphed, is well-deserved, and we think, probably insufficient. If a credit rating communicates the likelihood that a lender will be able to get its money back and its interest paid, then it is completely reasonable to downgrade the US still further. The only way the US can pay back lenders is by finding more/new lenders; our lenders are getting skittish and our government buys too much of our debt in its effort to force interest rates lower than the market would otherwise determine. Since the US borrows without the intent of paying down the debt, it has become a risky borrower. If anything, the credit rating agencies have been exceedingly lax in acknowledging this.
Then why have investors been BUYING Treasuries and driving yields down? Doesn’t that imply Treasuries are even less risky than before?
Ah, if only markets were truly efficient. Scared investors do scary things. We do not think that it makes sense to dump the stocks and bonds of profitable companies in order to buy the debt of a government that is being downgraded, but that is precisely what has happened over the past few weeks. Why would you sell the stock of a profitable company with excellent prospects that is paying a 2.5% dividend in order to loan money to a government that is finally being called into account for its poor fiscal management and charge them only 2.5% interest per year for 10 years? It’s a completely counterintuitive response.
For several years, we have advised that clients avoid US Treasuries and Agencies (other than Treasury Inflation Protected Securities after January 2009). That call hurt in October-November 2008 when Treasuries became a safe haven from riskier equity and commodity markets, but at that time, Treasury debt itself was not the cause of the crisis. Now it is.
But aren’t Treasuries the safest investment option during a scary time, even if the Treasuries themselves are causing the crisis?
US Treasuries are safe so long as the markets determine that they are safe. But consider some of the very tangible risks to the US Treasury market:
Imagine the impact if China, Russia, Korea, Brazil and other foreign owners of US Treasuries decide to sell into this rally and reduce their Treasury exposure and diversify across other issuers and currencies. They curtail or even cease new Treasury purchases. They announce their decision and scare other investors who also sell or reduce their purchases. Yields rise.
As yields rise, the value of Treasury bonds drops. If values drop enough, many investors may sell, particularly if they have total return objectives and are holding bonds that mature over longer periods of time.
If the duration of your bond is 4 years, then the principal value may drop 4% for every 1% rise in interest rates; if the duration is 8 years, then the value would drop 8% for every 1% rise. How much of a decline in bond values will investors accept if interest rates rise 1%? 2%? 4%? Will they really feel confident to hold to maturity? Some might, but that will not be the uniform response.
If sentiment grows that US Treasuries are not reliable and that the US dollar will continue to weaken against global currencies, then we can’t simply print our way out of this by issuing debt that our own government buys. Those who still think that the US Dollar is omnipotent and beyond reproach for all time and across the globe are ignorant of history and the other great civilizations that failed—as we have been doing—to take care of their day-to-day business like responsible adults.
Well, if Treasuries are not risk free, shouldn’t we just put everything into gold?
Gold is certainly an appropriate part of a portfolio, though far from the risk-free asset that some think it may be. Were it as risk-free as some wish, then we would not have seen gold stocks crashing this past week, nor would so many commodities have outperformed gold over the past two years as this crisis has been unfolding. Gold can whipsaw. It’s notable that while gold has appreciated significantly against the US dollar, it has not changed nearly as much versus stronger currencies. Ultimately, the world will settle on a price for gold and the rate of appreciation versus US dollars will slow.
Gold—whether bullion, futures, or related stocks—certainly has a place in a portfolio concerned about hedging currency risk.
Well then, what else should I be doing to manage my investments? Should I go to cash?
While it sounds cliché, every investor needs a portfolio that reflects their investment and/or business objectives, liquidity needs, tolerance for uncertainty, and long-term spending requirements. There are some investors who should be in cash, but then, they probably should have been in cash three weeks ago or three months ago when risky assets were far more highly priced and thus communicating more even more risk than they are today when 10-20% cheaper. There is no news this week that we did not know several months ago; the market is simply digesting a recent and high-profile policy-level failure to effectively address financial concerns about which many have known for some time.
There is no one answer to the question about the ideal portfolio for current events. That said, there are a few fundamentals that remain true:
1. High quality companies with strong balance sheets, compelling businesses, and strong management should over time provide shareholders a reasonable return on their equity.
2. When making loans to companies and governments (i.e. buying bonds), select those that are fiscally sound, likely to payback the principal and to make interest payments in a timely manner. Weak corporations, municipalities, or sovereign nations should be avoided unless you are being paid a substantial risk premium.
3. Commodity prices (energy, agriculture, metals) should appreciate over time if demand—or anticipated demand—for those resources increases. Depending on the commodity markets you are considering, look at the likelihood of increased demand and invest (or not) accordingly.
4. Real estate prices are impacted by two key factors. The first, is Location, Location, Location. You may not want to invest in office buildings in certain US downtowns or suburbs, but may find a shopping mall in the Czech Republic represents an excellent opportunity. The second is pricing and its doppelganger, liquidity. People need to live and work and play. That will not change. Real estate at a fair price makes sense.
In short, we do not see the Standard & Poor downgrade to be a reason to materially alter investment strategy unless your investment objectives have changed or you were not prepared for this environment in the first place. If your portfolio is overweight the US dollar and betting on low-quality companies, then this will be a rocky road.
As American citizens, we recognize that our country needs to do something dramatic about our revenues, expenses, balance sheet and financial decision making process. But we have been saying that for years now and investing accordingly. Perhaps S&P’s action gets the attention of a few more people who are willing and able to make a difference. If so, then we welcome the downgrade. Going forward, we hope that we can play our part in helping the United States earn back the financial credibility we once possessed.
