James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — If history is any guide, we will soon see a deal to lift the debt ceiling, followed by yet another cockamamie relief rally.

Don’t buy it; even if we get past the debt ceiling, and even if the U.S. can avoid a ratings downgrade, the situation facing U.S. assets is still grave. Firstly, cutting the deficit is a process, one with multiple opportunities over time for disruptive market events, but moreover one whose ultimate outcome, at best, is going to hurt corporate profits and suppress economic growth.

And even putting aside the impact of falling government spending, recent data shows a cooling manufacturing economy, consumers who are not consuming and a dangerously weak housing market.

While it’s possible that Aug. 2 arrives with no agreement to raise the debt ceiling and begin cutting the deficit, that outcome is a form of ritual suicide that both Democrats and Republicans will probably collectively choose to avoid.
That’s good — a default would be horrific — but a deal won’t change the terribly weak fundamentals now facing the U.S., and U.S. corporations in specific.

David Levy, of the Jerome Levy Forecasting Center, maintains that a $1 trillion widening of the federal deficit between between 2007 and 2009 was responsible, nearly single-handedly, for slowing and eventually reversing the economy’s decline. Take that away, and away it will be taken, and corporations have precious little to make up the shortfall.

“The already depressed and sluggish economy will be hard pressed to avoid a profits decline even if there were no deficit reduction,” Levy wrote in a note to clients.

“Present government baseline projections already include sharp tightening over the course of the next year and a half. That, in this economy, is a recipe for recession.

“Washington, Wall Street, and Main Street do not understand that the economy’s wealth-creation process is broken because there are already too many assets, carried at unrealistically high values, and paid for with too much debt. Trying to fix the economy by cutting the federal injections of profits will backfire, create misery and aggravate the balance sheet problems.

The critical point is the mismatch between assets, their carrying values and the notional value of the debt underlying them. Even if you don’t believe that can be cured through the issuing of more federal debt, it is easy to see the impact that cutting the debt will have. Profits will fall, and the clean balance sheets of so many corporations will not avail, because the busted balance sheets of consumers and the government will be unable to generate enough activity to justify current share valuations.

COOLING ECONOMY

Remember too that the U.S. is in the midst of a soft patch. The Federal Reserve’s Beige Book survey, released on Wednesday, showed economic conditions deteriorating in about half of the country, with weakness tied particularly to housing and manufacturing. Manufacturing has been one of the few relatively bright spots in an anemic recovery; should it falter, the U.S. will likely find itself in another recession by mid-2012.

Consumers are hunkering down, whether by putting off purchases of food and diapers in the days before pay and government assistance checks arrive or by putting off discretionary big ticket buys. Corning cut its outlook for the glass market on Wednesday, sending its shares and those of its rivals into a tailspin.

“What you are seeing is the major TV brands like Sony, Samsung, LG are all reducing their forecasts of what will be sold at retail,” Corning finance chief Jim Flaws told Reuters.

Consumers, Flaws said, are putting their money into items other than TV sets or “perhaps just not spending … at all.”
As for housing, there are more than six million homes either in mortgage delinquency or outright foreclosure. Those homes are going to take an enormous amount of time to clear the market, dragging down valuations and comparisons all the while, making mortgages tougher to get. In some parts of the country there really is very little real estate activity outside of the distressed sector. Don’t look for construction to pick up the slack, then.

The focus now is on what divides Republicans and Democrats what or whom to tax, what or whom to cut, who to blame. These differences are important, but the bigger picture is that there is consensus to cut, that the U.S. should enter an era of governmental austerity. That probably won’t change until after the beginning of the recession it will help to cause.

Austerity may be foolish, or it may be inevitable. This is open to debate. What is not debatable is that budget cuts will be terrible for corporate profits, and even with today’s fat profits, will expose current valuations as rich.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

A U.S. default or debt downgrade may set off market fireworks but the longer-term effects of the death of Treasury bonds as a universal benchmark of risk may ultimately be more significant.

The U.S. appears to be slouching towards a self-inflicted debt crisis, with Democrats and Republicans unable to agree a plan to lift the $14.3 trillion debt ceiling by the Aug. 2 deadline.

Even if such a deal is agreed, it may not be radical enough to satisfy ratings agencies, notably S&P, which has said it wants to see a $4 trillion reduction over 10 years. A deal on that scale seems unlikely by the deadline, meaning we may be looking at another round of negotiations in 2012, an election year.

All of this may be enough to push S&P or one of its peers into an exemplary downgrade even if there is no technical default, stripping the U.S.’s AAA status and risking an unpredictable chain reaction in global markets.

Even if none of this happens in the next few weeks, the larger truth is that the illusion that the U.S. is a solid-gold credit which can never default is lifting.

That concept — that the U.S. is the best possible sort of borrower, one that can never default — has been at the heart of the global financial system for decades. Investors have believed, mistakenly it turns out, that they can measure risk by comparing all credits to the U.S. Treasury benchmark. This has been an incredibly useful convention, giving financial markets a foundation upon which to build riskier investments, a means to gauge risk and a harbor to flee to when seeking safety.

The Treasury market’s ability to serve all of those functions will diminish over the coming years, not because the U.S. will default — it probably won’t — but because the words “permanent” and “risk-free” have meaning and everyone will now know they cannot be applied to Treasuries.

That’s bad for Treasuries, and will drive the cost up at which the U.S. can borrow, but it may prove to be worse for everybody else. A huge preponderance of all of the decisions and investments made in financial markets rely, directly or indirectly, on the concept of a risk-free rate.

The issue is not simply that the world will extract a higher rate of interest from everyone else because the U.S. is a less good credit, but rather that the process of figuring out who is a good credit and how to calibrate the relative difference of risk between one borrower and another is now infinitely more complex.

And, as complexity in systems is expensive, the overall cost of credit will rise.

RISK MISPRICED, CAPITAL MISALLOCATED

That’s actually probably a good thing, as the illusion of a risk-free U.S. borrower has led to an enormous misallocation of capital globally, from the fighting of wars the U.S. could not afford to the building of marble-clad bathrooms its consumers did not need.

Good it may be in the long term, but good it will not feel as it is happening.

My guess is that actually poorer credits will suffer more than Treasuries in the immediate aftermath of a U.S. credit event. If you no longer know where you are, you will try to take on less risk, like a driver who suddenly finds themselves in an impenetrable fog.

Think, for example, of the largest banks: people have been willing to lend them money based on the assumption that they are backstopped by the government, a AAA risk. The risk of lending to a too-big-to-fail bank does not rise in step with the rise in risk of lending to the government, but far faster.

Eventually, many corporations may be able to borrow more cheaply than the U.S. Already it is cheaper to buy default insurance on some large U.S. corporations than on the U.S. itself. The larger point is that everybody’s cost of credit will rise, because people are discovering that there is far more risk in the system than they imagined, and because the price of discovering that risk is far higher than we all assumed.

There is an irony too in the potential for a ratings agency to deal a key blow to the U.S.’s illusion of credit invulnerability. While some of the work done by ratings agencies was solid and some worse than useless, the fact is that investors before the crisis became far too reliant on ratings, and gave them far too much credence.

As faith in credit ratings ebbs, the cost of credit should rise to reflect the higher costs of actually doing your own analysis.
Shorn of our assumptions, we are all likely to charge each other more to borrow, slowing growth even further.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)