Evaluating the US Downgrade

The much awaited downgrade of USA’s credit rating took place today morning. The event was imminent the question off course was when and in line with the way market shaking news has a habit of happening in quick successions it has happened today. With the US Government debt moving up to levels of 100% of GDP and the lack of response of the US economy to the huge money printing by the US Fed along with the kind of political brinkmanship that we saw leading up to the Debt ceiling debate have led to this downgrade in simple lay man terms. Evaluating the impact and its repercussions could be a long topic so I propose to give my views in the form to questions. (Also I am attempting to be brief)

Will it lead to a risk aversion trade – The fact of the matter is that the risk aversion trade has been going on for several months now and is clearly reflected in the way the US Treasuries and German Bunds have rallied. UK Gilts went to all time highs a few days back. The US 10 year yields have fallen to levels of 2.35% yesterday. So what kind of risk aversion trade are we talking about, will money flow into the debt instruments or the currency of the country which has been just downgraded. I guess it will be perverse in a sense. The other trade could be move into the Swiss Franc or the Japanese Yen, which are already trading at all, time highs against the USD. Or would it mean a flow into gold that again is trading at all time highs. Can the downgrade of a country lead to a rally in its Treasuries? I guess not. As such as the initial panic (which ideally should not be there as AA+ is not really a bad rating and the next downgrade should not happen till after the US Presidential elections next year) the flow should actually be towards high growth Emerging Market assets. Why should anyone buy a US 10 year bond at 2.35% where the probability of a capital loss is extremely high. Moreover the US Dollar has got no yield support and as such given the interest rate differentials the USD should only depreciate against most currencies. In such a scenario, money flowing into US Treasuries seems highly unlikely to me.

What do the low yields of US Bonds reflect – More than the risk aversion trade I guess it reflects a failure of QE1 and QE2 whose purpose was to generate growth and inflation in the US economy. However a 10% fiscal deficit, weak currency as well at money printing equivalent to nearly 15% of US GDP has not been able to generate the inflation in the US that the Fed was targeting in order to fight the way out of low nominal GDP growth. All the money printing has not been able to create economic growth and employment in the US and has only been used by hedge funds for speculating in commodities. Infact QE2 and its failure is one of the key reasons of the US downgrade in my view. As such the low yields in the US reflect the view of market participants that the economy is unlikely to see any significant recovery for a prolonged period of time.

Will there be a QE3 – I believe that the downgrade totally rules out QE3 now as that could create conditions for a further downgrade in credit rating of the USA. There is no shortage of money in the system with overnight rates being almost zero. Infact banks have so much money that they are charging customers to keep their money as the credit growth is not happening. Although the inflation is not reflected in the numbers that are coming out of the US, however the reality is that the huge speculative move that QE 2 created in commodities especially crude and food prices has hit consumption in the US directly. Given that the US consumes nearly 22 million barrels of crude per day, the USD 40 per barrel that QE2 created hit the US consumers by USD 320 billion per annum. This is nearly 2.5% of the US GDP and given that incomes have not grown at that rate just the increase in oil prices has had the impact of taking away all the increase in incomes over the last one year. On top of that we have seen food prices across the board move up sharply and there was also a very sharp rally in fibre and fabric prices which when combined with higher wages in China has led to higher apparel prices in general. As such although official inflation figures show that prices are under control in reality the households are under severe stress. The high unemployment rate is also contributing towards poor consumption growth. As such QE3 is now totally ruled out in my view.

What happens to commodity prices – Commodities that have rallied sharply since the start of QE 2 will now absorb the new reality of slower global growth as well as the fact that growth is unlikely to be strong for some time to come. This will pressurize commodity prices. Hedge funds that have moved into commodities in a big way will need to reevaluate the new scenario and reduce their bets on commodities. We could see the correction of the commodity universe continue over the next few months before they stabilize given the fact the Emerging Economies will continue to grow strongly. (My prognosis in my article ‘Commodities and the demise of QE2’ seems to be now falling in place)

What happens to money flows – The reality of the situation is that there is huge money sloshing around in the global economy and given the slow recovery in the US and UK along with the stress in Japan we will see cheap money being easily available. Given the yield differentials as well as higher growth prospects of EM’s the money will seek out these countries for higher returns. The economies among the EM universe that can create enough absorptive capacity will see a deluge of capital once the initial uncertainty subsides. As such I would give around couple of months for people to absorb the new reality and subsequently money flow to EM’s should be very strong. I would think that this will be from October/November 2011. Given the fact that we had a trade out of inflation facing economies since November of last year this trade should reverse in a big way over the next one year.

What happens to Indian markets – In the short run the short term traders could dominate and we can see a sell of in equities. However I personally do not see any major reason why it should sustain. It is very clear now, looking at the way the equity markets have behaved over the last couple of weeks that this move was anticipated if not seen coming. Most European markets have corrected by 20% in a very short period of time, US markets by nearly 12-13% and most EM’s by over 10%. Normally the markets play the sell on rumor buy on news very well. As such we will need to see how it plays out this time. Equities are very cheap relative to growth prospects at this point of time and could become cheaper if the markets sell off due to this news. The two big concerns in India were inflation and the lack of policy making leading to low investment demand. Both these issues are likely to get resolved going forward.

Inflation is likely to fall much more sharply than what most people anticipate as the commoditi
es crack and there are clear signs of improvement in government decision making in the very near past. As such the high interest rate environment that was impacting demand as well as investments should see an improvement going forward. Nifty closed at 5200 on Friday and Sensex at 17300. Markets are at 12X 2013E earnings, which is cheap in the historical context (it can get cheaper for short periods of time) however will not sustain long term. India could have done much better had we not seen a panic rate increase by the RBI last month. I believe we are in a mid 2006 kind of situation where the concerns of Emerging Markets of that time is now there with developed markets. After making panic bottoms in the third quarter of 2006 most EM’s rallied sharply to new highs over the next one year. The probability of this happening this time around exists even today. India will definitely regain its favored investment destination tag over the next few months. The only issue seems to be technical at this stage with a number of charts having broken down from their key levels which could create a short term correction.

Investors should not be reactive on whatever happens next week as returns after panic sell offs tend to be quite robust. There seems to be no change in the long term prospects whatsoever due to the US Downgrade and frankly I cannot really see why there should be a sell off at all.