[Editor’s note: Tim Price, Director of Investment at PFP Wealth Management and frequent Sovereign Research contributor is filling in from London, England while Simon is touring agricultural property today.]
When Moody’s downgraded the UK’s sovereign credit rating last week it was something of an anti-climax.
The ratings agencies long ago lost what little credibility they ever had. Being downgraded by Moody’s is like being called a moron by a moron; ask anyone who has ever set foot in a bond dealing room– the ratings agencies are always behind the curve.
The UK has been on the skids, credit-wise, for years. Britain’s debt to GDP has gone through the roof. We, and generations to come, will be left with the reckoning.
We’ve seen this before in history. British debt to GDP peaked in the immediate aftermath of the Napoleonic Wars, the cost of which also brought in the ‘temporary’ measure known as the income tax. It wasn’t so temporary.
But as the peace dividend and Britain’s sole status as superpower flourished, debt/GDP ratio fell. With the outbreak of World War I, it began to rise again, peaking unsustainably as the Second World War ended.
By July 1956, British sovereign finances were in a dismal state. At the time, Egypt’s President nationalized the Suez Canal, putting British oil supplies at risk. Joining the fray, Saudi Arabia began an oil embargo against Britain and France.
Britain wanted to take action and went to the IMF for support. But sensing an opportunity to increase its influence in the Middle East at the expense of its faltering old ally, the US said NO and threatened to dump some of its massive holdings of UK government debt.
Britain’s foreign exchange reserves were running out, and the country would soon be unable to supply itself. Britain blinked first and bowed out. Our days of Empire were over. It came not with a bang, but with a whimper.
It is not unreasonable to believe that the exact same life cycle relates to the United States. Further, it is not unreasonable to think that the US’ day in the sun has already been and gone.
If its own high water mark was the fall of the Berlin Wall, at which point the world recognized the primacy of the free market model versus the failure of Communism, America’s ‘end of Empire’ moment has already passed.
Of course, like the UK, the US has already been downgraded (by Standard & Poor’s in 2011). This only confirmed what we already knew: given the absolute level of its indebtedness, the off balance sheet debts, and its broken political system, the US hasn’t been a genuine AAA credit for quite some time.
Yet even though its risk is obviously more than zero, US Treasuriues remain the credit market’s ‘risk free rate’. This is because bond fund managers operate dysfunctionally, favoring the debts of the world’s most heavily indebted countries.
Consequently, EVERYTHING is benchmarked to US Treasuries simply because the US is the world’s largest debtor.
In this context, the US downgrade was an act of spectacular significance. It punctured (or should have punctured) a bubble of suspended disbelief that just about every investor on the planet had been inflating for years: that the US was a riskless credit.
Or, even more ludicrously, that there was such a thing as a riskless investment in the first case.
And yet, government bonds become even MORE attractive after the downgrade. We may see the same in the UK.
Nobody believes that bonds are an objective reflection of economic reality. The game is rigged, and everybody knows it. But the Moody’s downgrade should serve as a piercing smoke alarm to anybody still naive enough to be holding these instruments of value destruction. Get out now while the going is good.
Director of Investment, PFP Wealth Management
Sovereign Research Contributor
PS. Mr. Price will be one of the many distinguished faculty members at Simon’s sold-out Offshore Tactics Workshop, which will take place in Santiago, Chile at the end of March. While it’s too late to snag a seat at the event, you can pre-order the workshop videos at a substantial discount through the end of this month.