Major Shift in Textbook Economics : USA is neither Risk Free nor the Safest Haven

United States loses prized AAA credit rating from S&P

http://ca.reuters.com/article/businessNews/idCATRE7746VF20110806?sp=true

Yesterday, Friday, August 5 2011, will be remembered similar to September 11, 2001 attacks (on the New York World Trade Center) when the world changed and will become a turning point in world history.

I like the line from the movie Apocalypse Now, as stated by Robert Duvall, a war movie based in Vietnam - "I Love the smell of Napalm in the morning". This quote is what you think of this morning, as we all wake up, when we hear that USA has lost its vaunted and seemingly infallible AAA rating.

I have suggested to many to move assets from equity markets for past month or two and sell even bonds in the last 2 weeks mainly to crystallize gains, sit in cash on the sidelines until the haze clears and we know, exactly, what the hell is going on? Markets will not only be extremely volatile but slide downwards.

Losing the rating is not much, but what matters in this context is the changing fundamentals, where to invest and how to be safe?

It was a matter of time before USA would have lost its rating. This was clearly being indicated by the melodrama, Hollywood style, happening over the last two weeks in US Congress with respect to the increase in USA debt ceiling, rise of which in itself if a very bad thing for the US economy. Further, the bond yields of various US Govt bonds were declining at a very rapid pace and the 2 year yield was close to 0.30%, 5 years was approx 1.25% and 10 year was at 2.5%. Chinese had stopped buying US Treasuries for last few months, while equity markets worldwide were volatile and sliding and there was nervousness all around including the usually stable price of copper which started declining last week.

Just like in 2008, when Bear Stearns and Lehman Brothers went bankrupt causing thousands of job losses, severe loss of income for employees, investment values in those two stocks in particular down to zero, equity markets to collapse and Central Banks worldwide to coordinate reduction in interest rates and 'bail out' of large banks in almost all developed nations with the major exceptions of Canada, Japan and Australia (in developed markets) That was ugly.

In 2011, things will get much worse in my view, because banks are still unable to lend in most parts of the world. In countries like India and China, interest rates continue to rise making a new type of problem arise where the borrowers are unwilling to borrow at high rates (caused due to low borrowing rates in USD and influx of such money into these countries leading to high inflation). We have seen the problems in both China and India where bank stocks have taken a beating, some are down 20 to 30% and some bank shares just refuse to rise despite profitability while loan losses rise tremendously.

In my view, things will not only be very uncertain but will turn nasty and lead all global markets even more downwards in the coming month. However, do expect a sharp rally in stock markets as and when the Governments announce some major policy action such as buy back of Govt issued bonds from banks or reduction in interest rates as we saw in Switzerland and Japan last week or when stocks of some companies become undervalued from their intrinsic book values or oversold, then there will be sharp buying leading to rise in equity prices. However, be cautioned, that unless you are a day trader, this extreme volatility may wipe out your investments before it comes back up to the same levels.

It is also my opinion that most things taught to us in school and universities that were held as 'sacrosanct' are being tested and failing as we live through unprecedented times where USA loses its rating, banks do not do lending, interest rates in Japan, USA, Europe, UK, Canada, Singapore, Switzerland are close to zero. Whereas, borrowing rates in countries such as Brazil, India, Venezuela, most African countries, Argentina, China, Pakistan etc are at historic highs and continue to rise. This disparity between the developed and developing countries will cause greater financial pressures in the coming months where all nations will become more inward looking rather than 'globalizing' further causing further declines in equity markets and aggravating the lack of borrowing from banks. Meanwhile, the real estate crisis in countries like Spain, UAE and USA will remain prolonged due to global headwinds.

We were taught that US interest rate is the only 'risk free rate' to measure everything against. Question is: If USA is not 'risk free' then how will those formulas work? Are they not useless now? What shall we measure risk against?

It seems the economists, writers of textbooks, Nobel prize winners and all, never contemplated that WHAT IF scenario, that will happen if their basic assumption of risk free rate itself is challenged and becomes useless.

It also brings to my favourite suggestion for the past 2 years to keep assets in different currencies.

With USA sliding gradually, other currencies will get some benefit and continue a gradual rise. This can be a hedge or protect value of your assets especially in such uncertain times.

This news of US rating downgrade will continue to have ramifications beyond the financial sector. It will impact politics in USA and change of thinking in countries like China and Japan who buy US Treasuries and lack of respect from emerging markets who always look upto USA as a global leader. Not to forget that economic uncertainty leads to unemployment and therefore, rise in crime and taxation or both.

What happens in countries like UAE, HK, and other Middle eastern nations who keep their currencies pegged to the 'strong' dollar, is still an unknown. Although UAE announced last week that they will not change the status of pegging with USD and HK has also announced that they are watching carefully but have not made any decisions yet. What was surprising in UAE that UAE does not hold any US Treasury bonds since last year or so.

Stay tuned for the most volatile week of your investment life next week.....Your guess is as good as mine as to what will happen, but markets are expected to go further lower and be very volatile......If you can, go short the markets so at least you can benefit from the negative news until it all turns around. I hate to say this but I did advise to go short over the last two months.

The point is, this downgrade has never happened before, so we are in unchartered territory where mass inertia or herd mentality will not work and neither anything we were taught in schools and newspapers will work. In such times, it is best to stay in cash and keep out of the markets, as much as you can.