Debt is Public Enemy #1

Robert C. Reeve with 'Big Mike', a record Alaskan brown bear. Kill the debt, kill the bear.

Robert C. Reeve with 'Big Mike', a record Alaskan brown bear. Slay the debt, kill the bear.

My grandfather was reported to frequently assert “debt is public enemy number one!” Nearly 160 years earlier, in 1816, Thomas Jefferson wrote “I believe that banking institutions are more dangerous to our liberties than standing armies.” Both of these sentiments transcend the sands of time – mostly because they are accurate.

Let us not forget that it is the heavily debt laden USA banking institutions that are a massive contributor to why the USA debt rating was revised from AAA to AA+ by S&P on Friday evening. It was only three years ago when the USA Treasury and the Federal Reserve came up with a plan to forestall our indebted plight. This effort, referred to as TARP, was supposed to stabilize and even reinvigorate the banking system. The idea was that the government could keep the teetering banks from failure by piling up debt instead of the banks. Since then numerous and similar efforts have come and gone, all without much benefit to folks like you and I. The USA debt balances have become as unstable as the bank debt balances were when this began. As most of us know in our heart of hearts, it just is not reasonable to conclude that a debt problem can be solved by issuing even more debt.

Germany knows this all too well. While S&P was figuring how to go about announcing its downgrade of the USA, Germany began to signal its increasing discomfort with the European debt situation. Why would this be? Under the new European bailout structures, only AAA rated countries can participate in the funding. That means a grand total of two: France and Germany. It is suspected that France is soon going to lose their AAA rating. If this comes to pass then Germany will be on the hook for covering debt that is 133% of its annual GDP (the total value of a country’s goods and services). Germany knows that throughout history nary a county has recovered from these sorts of debt levels – and it would not even be debt that they racked up! Now, Germany must contemplate the ultimate question. Are they willing to risk their sovereignty and future economy for their European spendthrift brethren? I suspect not. While Italy announced Friday that they will join other countries such as Greece in the selling of national assets to cover existing debts, I doubt that the Germans want to join them. This is one part of why the global markets are selling off – European solvency is teetering on the decisions of one country. For another part, let’s return to the USA.

With all of the news flow these past few months, many have managed to ignore the increasingly possible resumption in the implosion of institutions such as Bank of America and Citigroup. These and other banks are just not well enough capitalized to overcome another leg down in the USA economy. And as was recently discussed amongst these lines and in client meetings, that down-leg is here. These banks are also facing lawsuits as well as balance sheet consequences over involvement in poorly structured mortgage securities and related derivative products. Their stock prices have been sinking. This may be because they probably will have to sell new stock to meet regulatory solvency requirements . . . not to mention navigate and settle mammoth lawsuits. Share prices tend to decline on this sort of scenario. If capital cannot be raised then a large portion of the USA’s banking capability will be seriously impaired.

No wonder the markets – regardless of most asset classes except gold and silver – are whooshing downwards.

Now, add to this the downgrade of the USA debt. As the official Chinese news agency Xinhua commented over the weekend “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”

So on the first trading day after a downgrade of USA debt, what asset class would logically decline in value? US Treasuries and the USA dollar you say. Nope. Most large market participants who sold today maintain spare cash in the form of dollars. The dollars are automatically used to buy short term US corporate debt as well as treasuries that will be held until a new home is found. The increased demand for dollars, and thus treasuries, today caused their respective prices to rise. Notice that I did not say ‘value’. In the short term, markets can be considered price based voting machines – like today – but in the long term they are weighing machines that are better tuned in to actual value. So as folks figure out what to do with the funds that have been liberated by the massive selling across many types of assets these past few weeks, the world may witness something as original as the downgrade of USA debt; a serious and concerted flight from the dollar and treasuries too.

Also, it would not be a substantial surprise to find Germany the benefactor of such a process. In fact, just as we fretted five years ago that Europe was in grave structural danger, we are now considering that Germany could actually leave the European Union. This would cause the Euro to plunge by an estimated 30% to 40% yet allow the remaining participants to reboot their economies as their goods and services would be less expensive relative to global competitors. This would also allow Germany to return to its own currency but at a high cost. Its exports would suffer as they would be manufactured using relatively higher valued currency. There is a potential silver lining here though. Switzerland has cultivated a very strong currency for generations, and still manages to have unparalleled specialty food, precision instruments and pharmaceutical exports. Perhaps the ingenious Germans will also find their new niches too. As a bonus, the Germans would also maintain their sovereignty. Finally, it should be noted that they would also achieve something that they did not do in three military actions – European supremacy.

But again, I digress.

What do the above mentioned actions mean for investment portfolios? I believe that the debt downgrade really amounts to a currency downgrade. The debt will probably be paid, but with less valuable dollars. Also, the Federal Reserve and US Treasury are likely to have no other choice but to step back in and try something to get the economy reinvigorated. Using their familiar and predictable playbook they could announce another round of quantitative easing or some other method in which to keep interest rates low such an effort from the 1960s called the ‘Twist’ (no, I am not making this term up). This involves selling short maturity treasuries while using the proceeds to buy longer dated maturities in an effort to keep long term interest rates low. Whatever the case the USA dollar should continue its decade old trend of decline. Tomorrow, Tuesday August 9th, or August 26th, seem likely dates for this sort of announcement. If no announcement is made on these dates or on an emergency basis, the markets are likely to continue to experience price declines. As the caption at the head of this article says, slay the debt (through inflation or default), kill the bear (i.e. bear market). When will they pull the trigger?