Sovereign debt is traditionally considered one of the least risky forms of debt because governments can raise taxes (annoyingly referred to as “revenues”) through the political process. Because of this unique benefit their borrowing costs are lower than non-sovereign (corporate) bonds. But not all sovereigns are the same. S&P rates 19 out of 127 nations as AAA, which is its highest credit rating. The United States is the only AAA rated country with a negative outlook.
The negative outlook doesn’t mean that we have lost our AAA rating yet. In the ponderous credit analysis process, giving a negative outlook is announcing to the world that a downgrade is possible. The wording of the S&P release was looking ahead two years to 2013 as a possible timeframe for the downgrade to occur (if it were to occur). A lot could happen between now and then to change the outlook. The purpose of the statement was to put the bond market and Congress on notice. The stock market reacted with a 1% drop which is not that significant. The bond market didn’t react at all. Gold and silver spiked. In essence, financial markets already know.
Where do we go from here? There are three ways to get out of sovereign debt: grow the economy, create inflation, and default. The most desirable way to get out of debt is through economic growth which creates rising tax revenues. This requires policies that are friendly to small businesses whose entrepreneurship creates the bulk of new jobs in an expanding economy. Another option the United States has, that most countries do not, is to devalue our currency. Inflation robs all bondholders of real value because we’re paying back debt in dollars that aren’t worth what we borrowed them in. For the 23% of Americans that owe more on their houses than they are worth, this might be a small consolation. The United States is in the catbird seat because the dollar is the world’s reserve currency and we can “quantitatively ease” as much as we want, up until the point that foreign investors (especially China) stop buying U.S. Treasuries, which can happen rather abruptly. The third way to handle debt is to default on it. For most debt burdened countries that are not in control of their own currency, such as Greece, this is their only option.
We have known for thirty years that the federal budget is structurally flawed. Tough choices will have to be made and it will impact the lives of all American citizens and many foreign interests as well. More than ever, it is important that we vote intelligently and plan prudently. It is a very good time to take a good look at our goals and to position our portfolios to maximize the likelihood of attaining them. We’re in a different world today than we were five years ago. Five years from now, things will be different again. I am hopeful that it will be for the better, but I am planning for less favorable outcomes as well.