A Shrinking Distinction

“Barakalypse Now,” the Drudge Report declared yesterday, in reference to the plummeting stock market…and Barack Obama’s responsibility for it.

The headline is not entirely fair, of course. Barack Obama is not solely responsible for the nation’s skyrocketing federal debt, moribund economy or tumbling stock market. But he does have the best seat in the house from which to watch the carnage unfold.

With a seat that close to the action, one would think Obama could find a lever to pull or a switch to flip that could alter the course of events. But so far, the President has not found either one. Instead, he returns continuously to Old Faithful: Blaming someone else.

Standard & Poor’s is to blame for the stock market’s drop, says Obama. Presumably, the President would also blame weathermen for tornadoes, syringes for heroin addiction and concrete for traffic accidents.

Your editors here at the Daily Reckoning would not dare to blame Barak Obama and/or Congress for the mess the nation is in. But the stock market has no such qualms. It has cast aside all pretense of civility during the last several trading days to scream, “It’s your fault!”

For more than two months, the world fixed its gaze upon Washington – hoping for a credible plan to curtail America’s runaway deficit spending.  On August 2nd, Congress and the President obliterated that hope. The “historic” legislation the President signed into law that day triggered an historic market selloff…that gained momentum yesterday.

The Dow Jones Industrial Average plummeted 635 points to 10,810 – its lowest level in nearly a year. Meanwhile, gold soared $55 to a new record-high of $1,718 an ounce. Treasury bonds, ironically, also rallied.

“Treasuries Surge After S&P Downgrade Fuels Safety Bid,” Bloomberg News reported, without trying to be funny. Your editor laughed anyway. Only in an investment environment as confused (and confusing) as today’s could a rating agency create additional demand for a bond by downgrading it. But that’s exactly what happened. After S&P downgraded the credit rating of the U.S. Treasury, Treasury bond prices soared – pushing the yields on 1- to 3-year Treasurys down to all-time lows.

This is what panic looks like, dear reader.

Is the panic justified? Mr. Market will let us know in the fullness of time. But if we wish to get a jump on Mr. Market’s assessment, we may need to exercise our imagination.

Therefore, to continue the Daily Reckoning’s recent theme of imagining the unimaginable, imagine this:

The First might become last… and the Last, first.

Truth be told, you will not need a very active imagination for this particular exercise. The Firsts and the Lasts are in the process of changing places already…as the following series of charts illustrates.

The United States has the largest economy in the world. It is in first place. Until last Friday, the United States also had the highest credit rating in the world. It was in first place. For decades, in fact, the United States has been the undisputed Numero Uno, according to almost every relevant economic and societal metric.

But the United States is also #1 in global indebtedness. It is in first place. Nobody owes more money to more people that the U.S. So the downgrade by S&P is not really new news. It merely confirms what the macroeconomic data had been telling us for a long time: The U.S. is slipping economically. It is slipping from #1 to something lower.

Ditto, Europe.

Generally speaking, the mature economies of the West are slipping, relative to many emerging economies around the globe. The First have not become last just yet, but they are working on it.

Barak Obama, as well as the European Central Banks and the IMF would have us believe that Greece is an anomaly. They would have us believe that Greece is a one-off, or at worst, one part of a “three-off” that includes Portugal and Ireland.

But Greece is not an anomaly. It is not a one-off; it is a canary…in the coalmine of sovereign indebtedness. Countries like Italy and Spain – as well as countries like France and the United States – are down in the same mine. They are all inhaling the same toxic fumes of extreme indebtedness.

Throughout the mature economies of the West, government finances are in deep trouble, both in places we would expect and in places we would not expect…

Suddenly, several highly rated sovereign borrowers are looking much less deserving of the lofty credit ratings.

As we pointed out last week, for example, the price of a five-year credit default swap (CDS) on AAA-rated French government debt is higher than price of a comparable CDS on AA-rated Chilean government debt. [To refresh, credit default swaps are a kind of insurance against default. Therefore, the more likely a default seems to be, the higher the price of the credit default swap].

But the news in the Old World is going from bad to worse.  Today, the price of a credit default swap (CDS) on 5-year French government debt is not only higher than a CDS on Chilean debt, it is also higher than the price of a CDS on Brazilian, Peruvian and Colombian debt! All three of these countries carry a BBB- rating – just one notch above “junk.”

This pricing differential is shocking, at least within the context of recent history. For most of the last eight years, the price of insuring Colombian debt against default was much higher than the price of insuring French government debt.

But the relative pricing has inverted. Colombian CDS are now cheaper than French CDS. In other words, the CDS market is saying France is a greater credit risk than Colombia!

This verdict did not arrive overnight, of course. It has been developing for years, and is simply part a big, long-term trend that Chris Mayer, editor of Mayer’s Special Situations, calls the “Great Convergence.”

“The distinctions between ‘emerging markets’ and ‘developed markets’ are starting to disappear. Indeed, the terms may already be obsolete,” Chris observed in the February 25, 2010 edition of the Daily Reckoning. “Emerging markets now make up about half of the global economy.”

Over the last couple of years, the character of the Great Convergence has changed somewhat. The developed markets are slumping even faster than the emerging markets are growing.

Ten years ago, Portugal, Ireland and Greece were highly rated sovereign borrowers. Ireland was AAA. Meanwhile, Brazil, Peru and Colombia were all “junk credits.” The chart below shows what has happened since. Today, Brazil, Peru and Colombia are all investment grade, while Portugal, Ireland and Greece are all junk credits.

Not surprisingly, over this same ten-year timeframe, the equity markets of Brazil, Peru and Colombia have rewarded investors generously, while the stock markets of Portugal, Ireland and Greece (aggregate) have punished investors.

This glimpse into the past, we predict, will also be a glimpse into the future. Capital flees from abusive relationships and seeks out environments where it can be fruitful and multiply.

Therefore, as investment capital flows from inhospitable locations to friendlier ones, many of the world’s wealthiest nations will become poorer, and the poorer nations will become wealthier.

“All things must pass,” George Harrison sang on the 1970 album by the same name. “All things must pass away. None of life’s strings can last.”

That includes AAA credit ratings.


Eric Fry,
for The Daily Reckoning