Insights Aug11

8/3/2019 Insights Aug11

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DISCRETIONARY PORTFOLIOMANAGEMENT www.tradingportfolio.net

INSIGHTSThis is only the beginning

Fallout from the US Debt Downgrade

The U.S. Treasury Department

said there is no justifiable rationale

for S&P s move to downgrade the

nations credit rating on 5th Aug. Are

we all supposed to believe that the

mathematics behind the biggest

decision S&P has had to make in its

lifetime as a company will be offby $2 trillion as the Treasury

suggests?

What will it actually take for the

politicians in Washington to be

honest enough to admit their

continued excesses? US political

puppy Tim Geithner was on Fox

News in April specifically stating that

there was No Risk that US could

lose its AAA rating! With this rating

reality check, the fact that all other

developed - and developing countries

- are offering better returns than US

paper (okay, except Japan!) will now

come to the forefront even more.

With 18 other AAA rated countries

such as UK, Australia, New Zealand

having far higher yields, I personally

find it difficult to understand why

anyone would want to invest money

for 2 years at 0.25% (or below 2.5%

in 10yr treasuries for that matter) in a

country where decision makers are

fighting over doing the obvious,

whose currency is steadily declining,

whose unemployment is rising, whose

growth is slowing, whose population

is ageing and whose supposedly

robust onshore regulation doesnt

stop the LTCMs, Madoff s and

Lehmans of this world fromrepeatedly surfacing. With the US'

ISM manufacturing index falling to

the lowest level since July 2009, there

have not been too many good stories

to tell, recent payroll report

notwithstanding.

Structurally, Im quite clear that

this rating change is the first of the

many nails which the US economic

coffin will have to painfully bear over

the coming years. However, contraryto most expectations, I am not overly

bearish in the coming week -

probably the most keenly watched

and anticipated weeks of the

financial markets this year.

Yes, I do see some macro

headwinds gathering momentum.

The fact that Emerging Markets

will be leading the FDI flows going

forward will now get more firmly

entrenched in peoples minds.

With the fallibility of the US will

come up questions of the fallibility of

Italy and its Euro allies. The ECB

standing up and trying to support the

European debt markets (Italy &

Spain in particular) could be a short

lived fallback plan.

French banks alone own $511

bn of Italian debt, which is 20% of

France's GDP and more than twotimes as much as Greece owes

everyone. Italy - the 3rd largest bond

market in the world after US &

INSIGHTS FROM

SIGNIFICANT

OTHERS

2.1ON U.S. TREASURIES"There's no alternative that

provides such stability and

liquidity," says South Korean

Deputy Finance Minister Choi

Jong-ku, 6th August, 2011. Japan

feels the same

2.2

8/2011 BUFFETTOLOGYFinancial markets create their

own dynamics, but I dont think

were facing a double dip

recession. Clearly what stock

markets do have is an effect on

confidence, and this selloff can

create a lack of confidence

2.3EL-ERIAN, CEO, PIMCOIt will fuel uncertainties about

the functioning over time of the

world economy as there are no

other pure AAAs able and willing

to materially complement or

replace the role of the U.S. at the

core of the global financial

system

2.4JPMORGAN CHASE... estimated that a downgrade

would raise the nationsborrowing costs by $100 bn pa. A

U.S. credit-rating cut would likely

increase Treasury yields by 65 bp

INSIGHTS: TRADING PORTFOLIOS INVESTOR NEWSLETTER, AUGUST 7, 2011
http://www.tradingportfolio.net/http://www.tradingportfolio.net/


2/4

DISCRETIONARY PORTFOLIOMANAGEMENT www.tradingportfolio.net

Japan - is on the hook for about

twice as much as it took to bail out

Greece, Ireland, and Portugal put

together.

The forthcoming Italian debt

story is much bigger and important

news to me than what has (finally)

happened in the US of A.

No wonder sex starved

Berlusconi said that Italy will speed

up its fiscal consolidation timetable

and introduce a balanced-budget

amendment in its constitution as part

of an agreement with European

Union authorities.

Whilst overall USD bearish

sentiment will prevail, I reckon

EURUSD could see 1.4550 resistance

holding in the short term till much

more clarity is in place onshore.

Now if only China could offer an

internationally accessible robust debt

market with a fully convertible RMB

(offering twice the US yields and

scope for long term RMBappreciation), where do you think the

SWF money would ultimately flow?

Its happened before, and

didnt hurt too much

Japan saw a rating downgrade 10

years ago and its debt costs actuallydropped as the chart that follows

clearly shows.

The Yen has also strengthened

ultimately - in contrast to the case for

a much weaker USD after this US

rating cut in fact has been - with the

CHF - touted as a safe haven option.

Interestingly enough, when 56

out of the 60 top US corporates lost

their AAA ratngs (such as Berkshire

Hathaway - BRK, GE, Pfizer),

investors shrugged it off.

In fact, borrowing costs for BRK

and GE actuallyfellafter they were

downgraded in Spring 2009!

PART ONE OF

THE HARRY

POTTER SERIESThis is just the first downgrade.

JPM estimates that $4Tn worth of

treasuries are pledged as

collateral by borrowers such as

banks and derivative traders.

The change in status from one

ratings agency is unlikely to

trigger any immediate covenants

(a primer on Sovereign Debt

Ratings) but itmay take only onemore before borrowers are

required to come up with $$$ to

keep their creditors at bay -

essentially a margin call on

the US of A.

http://www.scribd.com/doc/61717721/KR-Sovereign-APrimer-Enghttp://www.scribd.com/doc/61717721/KR-Sovereign-APrimer-Enghttp://www.scribd.com/doc/61717721/KR-Sovereign-APrimer-Enghttp://www.scribd.com/doc/61717721/KR-Sovereign-APrimer-Enghttp://www.tradingportfolio.net/http://www.tradingportfolio.net/


3/4

A bit late to join the party?

Credit Default Swaps have said it all

The credit default market has

led the way forward in discounting

this rating change.

Even today, the price of

insurance on a US government

default has been higher than that for

Colgate Palmolive, the global

toothpaste giant, which has a ratingtwo notches below AAA.

However, European Swap

spreads have already priced in a

healthy spread of+90 bp, as the chart

below highlights. This also means

that the market is saying that

systemic risk in Europe has reached

significant levels. Not quite as high as

last year's panic, however, but high

enough to suggest that something

distinctly unpleasant is likely to

happen.

Similarly, market perceptions of

this downgrade was that it was quite

inevitable; in fact the United States

has higher debt levels than most

AAA corporate borrowers even.

Today, the US debt as a

percentage of the nations economic

output is 75% and could top 84% by

2013, according to S&Ps research.

The typical AAA-rated country has a

ratio of only about 11.4%.

Will international investorsabandon their USD holdings? Not

necessarily, and certainly not

immediately. Most of those investors

that are constrained to holding AAA

paper can do so as long as at least

two major rating agencies assign

these securities a AAA rating. Both

Moody's and Fitch confirmed their

US AAA ratings earlier this week.

The fact that Berkshire Hathaway is

the majority owner of Moodys may

just have helped?

Behind the scenes

The downgrade fine printS&P downgraded U.S. debt not

only because of the deteriorating

fiscal outlook, but also because of

concerns about Americas ability to

govern itself. Another important

point to note is that in the past thirty

years, five nations Australia,

Canada, Denmark, Finland, and

Sweden have regained a AAA

rating after losing it.Last but not the least, this

downgrade may set off a cascade of

further downgrades for other U.S.

debt.The federal governmentprovides an implicit or explicit

backstop for many other debt

securities. For example, the federal

government stands behind trillions ofdollars of debt and guarantees issued

by Fannie Mae and Freddie Mac,

GNMA securities, and securities

backed by guaranteed students loans.

One of the more obvious

anticipatory impacts this rating

downgrade already has had is on

global - and US - stock markets. Last

week was the biggest stock market

decline globally since October 2008.

A huge $2.5 trillion was wiped

off company valuations in the space

of a few days. Prolonged bickering in

the US over the debt ceiling, lack of

ECONOMIC

CALENDAR

MONDAY, 8 AUGS&P comes out with more details

on impact on related US debt

TUESDAY, 9 AUGUK Industrial Production & Trade

Balance US FOMC Chinese Ind Production & CPI

WEDNESDAY, 10 AUGChinese Trade Balance

THURSDAY, 11 AUGUS Initial Jobless Claims &

Trade Balance

FRIDAY, 12 AUGEuroland Industrial Production

US Retail Sales

MARKET LEVELSEUR 1.4278, Gold 1652, Dow

11445, 10Yr US Note 2.56%, CHF

0.7673

LIPPER FUND DATAIn a sign of how nervous

investors have become, data from

Lipper showed investors pulled

nearly $66 billion from money

market funds in the week ended

August 3, the second-largest

weekly net outflow on record.

The record outflow was seenduring the week ended

September 17, 2008.



4/4

political leadership and cohesiveness in Europe, economic

slowdown in major world markets & a sharp increase in the

fear factor for consumers has not helped the cause. US rates

to remain unchanged and maybe even a case for QE3...?!

What Next?Where do I put my money?At the outset, it is a foregone conclusion to me that one

has to be nimble & flexible in todays financial landscape.

An increasingly shorter time horizon and investment into

highly liquid vehicles where there is full transparency and

accountability is clearly the order of the day. My trading

gut feel tells me to be a part of the herd for now, with the

clear preparedness to jump ship once any sign of contagion-

reversal price action happens. Nervousness was seen in the

6% drop in Tel Aviv stocks today, and though Saudi stocks

recovered after a battering yesterday, Egypt was down 4.2%& Dubai 3.7%.

My feel, however, is that most of the bad news has been

factored in this recent vicious selloff, and whilst there may

be further selling - both of US stocks and bonds - in the

coming weeks, a full blown rout is no longer on the cards.

In fact a lot worse has been witnessed all across global stock

markets without getting the kind of attention that one week

of US stock selling has. Which can be interpreted to mean

that more selling is quite feasible as US investors cash out.

The more obvious investment conclusions - for now -

would be to stay long Gold, long AUD, CAD and continue

a long UK Gilts stance. I would first let the herd lose steam

& then buy EURCHF and EURJPY. And yes, to be long US

Treasuries once the selloff is first seen. Hard assets such as

agricultural land, mining concessions and lower income

housing projects in developing countries continue to remain

my long term bets. Ideally, Id be bullish a commodity play

wherein the industrial metals (silver, copper) and agricultural

products far outweigh a pure Gold allocation in tomorrows

commodity basket. Id also actively investigate bond & stock

investment opportunities in the emerging markets, especially

through liquid financial instruments. Long Indian Rupee

through an 11% yielding A rated corporate bond is

certainly appealing with everything else collapsing! I also see

a greater importance of Chinese RMB assets going forward,

especially with an inflationary peak around the corner.

RMB as a reserve currency... hmm... cant rule out that too!

What is also important to recognise is the difference

between expected fallout and actual issues. There

already seems to be a fair amount of negativity priced into

the markets, in a regulatory backdrop wherein an attempt to

be better is firmly underway. Fiscal prudence has finally

become the international buzzword, and hopefully that

theme will drive a serious change in the way Governments

spend money and manage their budgets going forward. An

economic cleansing, if you may, is well underway, and

the memories of the Q4 08 to Q1 10 period are very much

fresh in the minds of regulators and investors alike.

I would not rule out concerted Govt efforts to quell any

panic, and some signs of this were witnessed by the

intervention of Japanese and Swiss authorities recently.

Expect more of the same. Stay nimble, stay calm, and mostimportantly, stay tactical in your asset allocation. Contrary

to what theory suggests, market timing is never a bad thing.

All the best! Ricky Husaini, CIO, Trading Portfolio

WHO SAID U.S.

STOCKS WERE

DOWN THIS YEAR?With a loss of4.6% YTD for the

S&P 500, U.S. stocks are performingrelatively better than the stocks of

other developed economies. Equities

in Italy & Spain have entered the bear

market territory (FTSE MIB & Bovespa

off by more than 20% YTD). Germany

is down by 9.8% compared to double

digit losses of the British, French,

Spanish & Swiss indices. Brazil & the

emerging countries of India (Sensex) &

China (Shanghai Composite) are also

down more than 10%. The commoditybased developed economies of

Canada & Australia are all off more

than the U.S., but still lower than the

crisis-ridden European countries.


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Insights Aug11