Last Friday, Standard and Poors made a historic downgrade of the credit rating of the United States from AAA to AA+. The other major credit rating agencies (Fitch & Moodys) left the U.S. at AAA. Frankly, they need to grow a pair. This downgrade was well deserved and there will be more to come.
Keep in mind our budget was in balance just over a decade ago. Since then, spending has been growing at warp speed while tax revenues have tracked the economy. Republicans, who are always yapping about being the party of fiscal responsibility, saw gross public debt go from $7.1 trillion to $12.4 trillion, for a rise of 77% in eight years with their guy in charge. After that, we got change, and debt began to increase even faster. If recent estimates are in the ball park, four years of Obama will produce $7 trillion more debt. By 2012, gross public debt is expected to amount to $19.3 trillion, a rise of 54% from 2008. By the way, this projection is AFTER the recent debt ceiling compromise. It should also be mentioned that what’s not included in the debt is the present value of the entitlement programs promised to those of us that are still breathing. That amounts to approximately $65 trillion more. For reference purposes, tax receipts in 2011 are expected to be around $4.5 trillion.
At brunch recently, a friend asked if it’s fair to compare families and governments when it comes to the ability to live beyond their means. It was a great question as the United States has become the equivalent of a family that earns about $60,000 per year and spends $100,000 per year. My answer was that either one can only do this as long as someone else is willing to lend them money. Governments can usually get away with this longer than families, but there’s a limit as Greece has shown. It doesn’t help that many of the countries currently lending to us aren’t what anyone would call BFFs.
Investors were shocked, just shocked, that a deteriorating balance sheet in the U.S. could lead to a lower credit rating. Recent studies have shown that investors are getting worse at discounting the future and instead tend to react hysterically to news announcements that were predictable. The recent week is a case in point. I'd love to tell you that things will return to normal and all this will go away. Unfortunately for the U.S., we’re probably undergoing a transition to a new normal.
In this new normal, the U.S. will lose its 150 year reign as the largest economy in the world within a decade. Economic growth in the future will be less than it has been in the past and any population growth will keep the unemployment rate high. With money market yields at zero, bond yields around historic lows, and stock market returns likely to be impacted by lower economic growth, it will take the next generation longer to build up a nest egg for retirement if they keep their investments in the U.S.
With bond investors reacting to the recent downgrade of the U.S. by buying Treasuries, this is a good opportunity to get rid of the last Treasury or Agency bonds in a portfolio. Now that the U.S. is officially a deteriorating credit and current yields are significantly less than the inflation rate, there’s no value there.
Winston Churchill one said the U.S. will do the right thing, once they've tried everything else. I hope he's right and we finally get it together. However, hope isn't a strategy. In this environment, it makes sense to shift both equity and and fixed income investments to countries that live within their means, offer bond yields higher than the inflation rate, and have the economic growth prospects necessary to produce decent returns in their stock markets.
Wisdom Tree ETFs, particularly ALD and ELD are a great way to do this on the bond side as they offer sovereign debt exposure in local currencies. Maturities are intermediate maturities and mostly do a good job of limiting their exposure to countries that have sound balance sheets.
On the equity side, the countries that keep taxes and debt low and live within their means are likely to continue to show the most rapid economic growth. These include China, Indonesia, Chile, South Korea, and Malaysia. All have ETFs available including ECH, HAO, IDX, EWM, and SKOR.
Disclosure: I am long ALD, ELD, ECH, HAO, IDX, EWM, SKOR.