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Vol. 284 - Credit Rating Downgrades Are Coming
There are many threats to the global economy and our markets in North America. QE3 can only temporarily subdue these growing threats. Dramatic structural reform in fiscal policy is what is needed. In the immediate future, no threat is more serious than the potential credit rating downgrades facing member states of the EU and the US.
We all remember the fiasco surrounding the debt ceiling in the US last July and August. It resulted in the first ever downgrade of US debt. This came after the US failed to get its fiscal house in order, delayed budget cuts over a 10 year period, and raised the debt ceiling substantially in order to continue running trillion dollar deficits. Although things seem much calmer at the moment, the US is on a fast track to hit its recently set debt ceiling of $16.39 trillion before the end of the year. The reality and potential impact of this event should not be far from investors' minds.
It is all but a guarantee that the US debt ceiling will be raised, just as it was in 2011. Default is simply not an option because it would not only throw the US into a depression, but the entire world.
Following the downgrade of 2011, markets around the world, including the three major indices of the US, experienced their most volatile week since the 2008 financial crisis. The Dow Jones Industrial Average plunged 635 points (or 5.6%) in one day. Gold, on the other hand, rallied to new all time-highs shortly after the downgrade, as the money supply exploded and the US Dollar tanked.
The fact that the Federal Reserve has been the main buyer of US debt likely sends chills down the spines of those countries holding large quantities of dollars. This fact alone has been a catalyst forcing many central banks to be net buyers of gold, the only non-manipulated currency in the world.
If the US economy does not kick into gear soon, the Fed's $40 billion a month purchase program in mortgage backed securities (QE3) will soon turn into $50 billion a month and then $60 billion and then more. Imagine that; the Fed is the biggest buyer of US government debt and mortgage debt. The two most vital debt markets in the world are being supported by artificial demand.
We are still a few months out from the US debt ceiling crisis being at our doorstep. Although euro zone nations know how to overspend almost as well as the US, they were not casual enough to create an imaginary debt ceiling - a fake threshold politicians pretend they can't cross as a way to demonstrate their fiscal responsibility.
European Economies Collapsing
Europe has its hands full with many issues, such as an expanding recession and PMI (manufacturing) numbers that would make any economist cringe. Europe has seen its manufacturing numbers free fall for over a year. In September, the composite PMI indicated that private sector output declined at the fastest pace since June 2009. What's almost unbelievable is that manufacturing has contracted for the 12th time in the past 13 months.
In respect to the EU, outside of Ireland, the vast majority of austerity measures have been missed, postponed and delayed as economies in Europe continue to contract. Many newspapers and online articles support a 'realistic' timeline for countries to meet austerity measures and suggest countries such as Greece and Spain need more time and more money before their economies will improve. France is a perfect example of a country which continues to run deficits and rack up higher than allowed debt limits with little or no recourse.
France's public debt soared higher in the second quarter and now sits at 91 percent of gross domestic product, according to the national statistics office INSEE. This is a shocking increase, which saw French debt climb by €43.2 billion in the second quarter alone. That may not seem like a lot compared to the US' rapidly rising debt, but considering that France's economy is just 1/6th the size of America's, it's a huge increase.
France's Finance Minister, Pierre Moscovici, pledged to get the French deficit back to an acceptable level by next year. This is the definition of kicking the can down the road. No politicians want to face the fiscal threats head-on.
The European Union has a rule that member states must run public deficits of no more than 3.0 percent of GDP. France has failed to follow this rule quarter after quarter, and is coming under increasing pressure to get its fiscal house in order.
Moscovici, France's Finance Minister under pressure, commented that the deficit limit of 3.0 percent was not established "out of thin air, three percent is what will let us reverse the debt curve in 2014, and I want to be the minister of debt reduction."
The above quote is a classic example of attempting to appease both the critics and those at home. It is always next year or the year after that. These countries, including the United States, will not learn until the market once again teaches them the true meaning of 'sound money'. Until then, the mindset remains desperate and hopeful that the respective economy will ignite and bail out the politicians and policy makers.
Moody's and other credit rating agencies are no doubt preparing to make some harsh cuts to nations around the world who are failing to make appropriate fiscal cuts. The debts keep rising and the economies keep shrinking.
Spain finds itself at the top of that list as Moody's has said it may cut the country's debt to "junk" status. If this were to occur, it would result in further cuts of its banks and several companies to junk.
This is something the ECB cannot stop. No matter how much debt the ECB, or other countries, buy from Spain, if the economy continues to flounder and no realistic path to repay its mounting debt is put forth, it will be downgraded. A downgrade would trigger a wave of selling from institutions who can only own bonds with investment-grade ratings.
On Thursday, September 27th, in a last ditch attempt to comply with the ECB and Germany prior to asking for another financial bailout, the Spanish government unveiled a draft budget for 2013 that cuts overall spending by €40 billion. This is significant and will likely give Spain an edge when it heads to the bargaining table, but does nothing to stimulate its dying economy.
Spain is not a small economy and in 2011 it was the world's 13th largest, with GDP of more than $1.4 trillion. Spain edged out Canada by less than a hundred billion dollars. This will likely be the last year Spain claims a larger economy than Canada, perhaps for a long, long time. France and Italy are even larger than Spain and currently lay claim to the 9th and 10th largest economies in the world. If Spain's debt is downgraded it would open the possibility to an overall weaker euro zone and the downgrades of more member nations. More importantly, it would bring about the realization that more bailouts simply pile on debt and make the odds of paying off the debt lower every year.
In respect to the United States, by early November fears about hitting the debt ceiling should be in full-swing. This issue will be on deck immediately following the election. For this matter, it is irrelevant who wins the election as the result will be the same. The debt ceiling will be raised. This could trigger the second debt downgrade in America's history.
When the US was downgraded in 2011, the Dow and global equities imploded while gold soared more than $50 an ounce in one day - and eventually went on to its all-time record high of over $1900 an ounce. If the debt ceiling is raised to $18 or $19 trillion, the US credit rating will be in jeopardy once again. Gold, for all the wrong reasons, will see its brightest days ahead.
All the best with your investments,