Monday, August 8, 2011

Market response to downgrade reflects loss of faith in S&P, not US securities

As Asian and European markets dropped and futures for US stocks followed, the blame is being placed on S&P's downgrade last week of US securities from AAA to AA+. Little note has been taken in the media - or in Washington - of Moody's continued AAA rating, or, more to the point, of the reasoning behind the S&P downgrade.

Consequently, the narrative about the apparent loss of investor confidence has been, to say the least, fuzzy.

First, it should be noted that the "investors" we are referring to are not lay people - they are sophisticated professionals (recent history and tendency towards herd behavior notwithstanding), and their investment decisions generally rest on substantial research.

Such research would include a read of the actual S&P document which announced the downgrade. Within that eight page document, it becomes clear that the basis of the downgrade was political - it decried the failure to cut such "entitlements" as Medicare, "the containment of which we...regard as key to long-term fiscal sustainability" while failing to even mention the three "hot" wars (Afghanistan, Iraq and Libya) and hundreds of military installations around the world whose aggregate costs exceed the on-going and accrued deficits.

Although the foregoing facts are unknown to most of the American public (thanks to the so-called mainstream media and the political class), these are not unknown to institutional investors. Regardless of their political sentiments, investors know that simple math illuminates the cause of the fiscal drain, and the failure of S&P to even mention, let alone factor, these into its assessment, undercuts again the value of these ratings in making investment decisions.

It should be noted that these same ratings agencies were certifying what were essentially junk bonds - high-risk sub-prime mortgage-backed securities - as top grade investments almost to the minute of their collapse. Investors do remember this, even if it has essentially dropped off the radar of the media and the political class.

So when one of the most prominent among them takes what is an essential function to investors - rating investments for safety - and politicizes it, it necessarily undercuts faith in the entire system.

Investors also know that, regardless of S&P's opinion, and of any apparent political gridlock in Washington, the US is fully capable of paying its debt, and that ability has remained unchanged.

Thus, it appears more likely that sophisticated investors, if they are reacting to the downgrade, are not holding a changed opinion of the intrinsic value of investments in US government paper; rather, they are feeling a lack of confidence in the value of the ratings agencies upon which they heavily rely.

Given the relative track records between the US Treasury - which has never defaulted in the 235 years since 1776 - and of the ratings agencies in recent history, it is clear where the basis for a crisis in confidence lies.

ADDENDUM: Some fundamental things that were left out of the assessment include

Undertaxed upper-income earners and multi-national corporations, creating a huge hole in revenues;

Public policy favoring exodus of jobs to lower-wage jurisdictions, creating a hole in revenues from working-class taxable income, loss of purchasing power and increased demand for credit;

Public policy favoring exodus of capital to higher-return jurisdictions, increasing need for return-on-investment domestically. Much of the income earned is either non-taxable or receives preferred (i.e., lower) tax treatment.

Again, these are politically determined omissions. The facts themselves are well known to investors, and the economy, under these conditions, is widely recognized by experts as being unsustainable.