Credit Quality – AAA decline
The market made another solid attempt to move higher and breakout of this week-long stagnation. It seems that last week was a waiting period to see if the Cyprus situation would have larger fallout, but so far it has had very little impact to the global financial markets. What the Cyprus crisis will do is define how future bailouts and bank failures in Europe will be resolved, or maybe not. Some have indicated that the Cyprus situation is unique; a one-off. Regardless, so far the global markets have shrugged off any concern and seem to be back on track. The situation in Cyprus is bringing renewed concern about the credit quality of sovereign nations.
The club of AAA credit quality nations is shrinking as nations pile on more debt, continue to run huge unsustainable deficits, and many run without a budget. The US, UK, and France were the three big nations that have been booted from this coveted club. There is a significant difference, however, between those nations, like the US, that can PRINT more money vs. France that must go out and raise money through bonds. Clearly the US will never default, simply because they can always just print more money to pay off any debt. The problem is not that they can’t technically default, but lies more in the worth of the money if they are forced to take the drastic action of printing more to pay that debt.
QE destroys credit quality
As some have correctly pointed out, we are already there in the US. Since the start of the credit crisis in 2008, the Fed covertly started printing and buying US treasuries to support the bond auctions. When they were caught with their hand in the cookie jar and hauled before Congress, Bernanke claimed that this decision fell under their “Emergency Powers” to avoid a default (failed bond auction). It was a huge moment in our nation’s history, for the Fed stepped far beyond its role and took what would normally be Congressional and Treasury powers into its own hands, for better or for worse. The Congress wrapped his knuckles and proposed that they put a policy in place that gets Congressional blessing, rather than letting the Fed continue to shoot from the hip. Quantitative Easing (QE) was born, officially. Before the Congressional sessions, QE was already going full swing – as a covert, bastardized operation.
The Fed’s expectations, as they explained their QE plan to Congress, where that it would be a one-time, short-term policy to make sure the nation got through this economic crisis. It was initially known as QE, not QE1. We only started adding numbers to it, as it became apparent that we needed to continue. Now after QE1, QE2, and Operation Twist, we are now at QE3. However, the TERMS have changed. Rather than a specific amount of money printing for a specific amount of time, it is now infinite in the amount and with no term limits. It shouldn’t be called QE3, but rather QEI (I for infinity).
However, we can’t lay the blame at the Fed’s feet. A big part of the blame falls on Congress and the Senate. Bernanke has pleaded with them that they MUST limit their spending, cut the deficit, pay down debt, and get control of government finances – perhaps passing a budget would be a good start. The Fed’s QE policy did help keep the nation from falling further into an abyss, but now it has just become an enabler.
How big is QE? Well, when it first started in covert fashion (before it was officially called QE), the number of bonds the Fed needed to purchase to keep the bond auction from failing at the FIXED rates was about 20%. By QE1 we moved up to 30-40%, QE2 reached over 50%, Operation Twist (holding up the price of the long-term bonds) was at 60%, now with QEI they hit over 70% in 2012 and this year it is already over 80%. Perhaps we will hit very close to 100% financing by 2014.
It is THIS fact that is a huge factor in calculating the credit rating agencies downgrade of the US credit rating. While we hear lots of talk about the “debt ceiling”, “fiscal cliff”, and “sequester” as the REASONS – one only has to follow the money. WHERE is the government getting the money to fund its deficit spending? When does the Fed reach 100% of government deficit funding? We are fast approaching that level.
We KNOW that the Government will not default on the bonds, because the Fed will just print more. What is the paper money worth at that point? Right now, no one is totally sure and the one saving grace is the stock market. Companies HAVE real intrinsic value and growth and to some extent as long as they are priced in dollars (as a measure of that value) it is certainly a huge help in keeping value in the paper dollar.
Courtesy of ShadowStats.com ShadowStats.com
AAA rating declines by 63%
“AAA” rated assets were just at $11 trillion in 2007; today the total value of all “AAA” rated assets has fallen to $4 trillion. The majority of this decline has come from these sovereign nations, primarily in the West, that have run up massive debt and continue to deficit spend.
BBB expanding – emerging market growth!
So we know the West is in credit decline, but are there any credit upgrades out there? Sure there are, but they are just not getting the press coverage that the “AAA” downgrades are getting.
The emerging market “BBB” range credit pool is growing, and fast. More and more emerging markets are lifting their credit ratings because of REAL GDP growth. These nations are no longer just export nations as their citizens are seeing a rise in pay and a booming middle class. Disposable income is creating demand for more goods and services. When I was in a Thailand suburb, there was a MASSIVE mall (8 stories) with all sorts of shopping. It would make any shopaholic in the US green with envy. People were spending; and it wasn’t tourists, it was locals.
These locals still have a long way to go, however, when compared to the pay in the Western nations. There are several positive factors in place; job creation, increasing pay, and very little, if any, debt. Many of these people in the emerging nations are spending EARNED income, they have little clue about the debt consumption that is prevalent in the West. When credit comes online big, like in the US and Europe, the boom in these emerging markets will skyrocket. Imagine 100s of millions of new credit cards, with even just a $1000 limit. That is LEVERAGED spending and that will certainly boost GDP. No doubt, in time, just like the West, it will eventually create a huge leveraged debt bubble.
Who knows when, but for now it is this demand in the emerging markets that is driving the global economy. Remove the emerging market growth, China, Russia, Brazil, India, and the rest – and the Stock Market collapses. Remember that over 50% of the revenue generated by the S&P 500 companies comes from overseas and that is growing – the fastest growth is in the emerging markets.
The Credit Problem
We now come back full circle to the Credit problem, which eventually determines the strength of the currency. When (if at all) will a currency from one of these emerging market economies begin to become the reserve currency?
It could happen several ways; a few examples would be:
– China refuses dollars for direct exchange in trade, forcing currencies to be converted first to their local currency for all goods. This could happen if/when the Chinese fully unpeg their currency from the US dollar.
– OPEC could price oil in a different currency or currency basket. This would force many nations that buy oil to start buying currency reserves in whatever currency OPEC prices in.
- Local business could stop accepting dollars or carry two prices on all goods (one in dollars and one in another currency). For those that travel to other countries, this is frequently done and usually the products priced in dollars are at a premium. This could happen in the US, especially for businesses along the Canadian border or perhaps the Mexican border and just spread further.
Any of the above is possible, some may just be improbable. My personal belief is that the stock market and the US global companies have far more to do with giving the US dollar credibility than our US government or the Fed for that matter. Remove the S&P 500 companies and the Dow 30 companies from the US stock market and list them solely in another foreign market, and you would see the dollar value collapse. The weight of national debt and deficit spending and the true value of the dollar would decline quickly.
Italy Credit – weak bond auctions send Europe markets lower.
I write about Credit Quality this morning, because the pre-market futures are under pressure as we see the failure of credit quality hit the shores of Italy. After a circus and failed election between a convicted comedian (Beppe Grillo) and a deeply corrupt leader (Silvio Berlusconi) winning such huge support 25% and 29% respectively, the winner (Bersani) doesn’t have a coalition of control; he only has 30%. Grillo is leading the nation down the road of Socialism/Communism, which is becoming ever more popular in the Mediterranean. Berlusconi is so corrupt that there is little hope of any resolution. Poor Mario Monti; the only person with an ounce of accountability and responsibility only has 10.5%.
The election just caused a big mess and this morning Italy needed money and their bond auctions for new 3 & 15 year government bonds had a poor showing, forcing interest rates up to the highest yield in months.
The European markets came under pressure after the very week Italian bond auctions. It was a clear reminder that while the Cyprus issue is coming to a suppose resolution, the credit problems in Europe remain.
Spain, Italy, France, and others will continue to need money and the political leaders of these nations are becoming more and more socialist and we are seeing a rise in communism. A growing number of people, in troubled economic times, want the government to pay for everything. The governments just don’t have any money and it is this vicious cycle that is creating more debt, more risk, and of course credit rating downgrades.
Support & Resistance
We got above 14,500 yesterday in strong fashion, but the pre-market futures are again looking week. Is 14,500 becoming a straddle strike or is it still resistance?
We just can’t seem to get above the 2800 level. A story out of China this morning showed a huge slow down of building Apple (AAPL) and Dell (DELL)equipment at FoxConn. Has demand fallen? It seems so and that could mean that forward earnings might be weaker than expected.
We are above the 1550 level, but it is still not looking very solid in the pre-market. I would continue to look at that 1550 level as a straddle strike area. The VIX dropped below 13 yesterday, but I think, based on the pre-market futures, the VIX will bounce back to the mid to high 13s.
The broader market is just not getting the solid order flow to push this index higher. The Cyprus situation put the world markets on pause and it looked like we may get through it. However, Italy is becoming a headline again and that is shaking European confidence.
The Credit Quality contraction in the West is just a reflection that there is a huge global shift in economic power from the debtor nations to the creditor nations. The emerging markets are on the rise as the West faces the painful reality of debt and deficit.
I would stay far away from US treasuries and European debt. International companies are a far safer and better investment than any Western debt. Sure, you may get a good move on some Italian or Greek debt (picking the bottom with a short-term rally) as they may get another can-kick bail-out; however, that is a risky trade and not a solid or safe long-term investment.