Tags: U.S. Economy

Wrong, Again: S&P Upgrades U.S. Outlook

By , Money Morning •

If you're not familiar with the term "putting lipstick on a pig," well I think there is an apt example at play again from the people who seem to be experts at applying the lipstick.

Standard and Poor's this week raised the outlook for the U.S. credit rating from "negative" to "stable," citing reduced fiscal risks and policymakers' willingness to sustain growth.

Oink. Oink.

There's another recession wave coming, and the U.S. economy is ill-prepared to take the hit.

But that doesn't mean you have to take it on the chin. You can prepare yourself by shunning one investment and looking to a surprising sector that at first glance wouldn't seem a great port in this storm.

Just Look at the Business Cycle

I have always been surprised by commentators' failure in their budget predictions to take account of the business cycle.

In 2001, the Bush administration forecast continued budget surpluses, and the major media agreed with it. Yet there was no "there" there. Like everyone else, I could see we had entered a recession, yet nobody was taking account of it.

I stuck my neck out in late spring, and forecast a deficit of $200 billion for the year to September 2002. I was first to forecast a deficit - and way short of the $317 billion deficit that actually occurred.

A Poor Standard

This time around, Standard and Poor's optimism focused on the improvements in the budget picture caused by two factors: the restoration of the payroll tax and modest upper-bracket tax increases of January, and the "sequester" spending cuts in March.

The sequester in particular was a brilliant piece of policy; it appears to have had almost no effect on the operations of government (thus proving there was massive bloat) and has produced the first real cuts in spending since the 1990s.

As a result, according to the Congressional Budget Office, the deficit for the year to September 2013 is a mere $642 billion, or 4.0% of GDP.

That doesn't sound too worrying. Unfortunately, two special factors are holding it down and are likely to reverse. First, Social Security and Medicare payments are likely to increase rapidly as the Baby Boomers retire in greater numbers.

Second, Ben Bernanke is buying $85 billion of government and agency debt monthly - that's over $1 trillion a year. With a deficit of only $642 billion, that's really jamming interest rates to the floor.

Now interest rates are showing signs of increasing, and by late 2014 they are likely to have risen close to their long-term averages of 2-3% above the rate of inflation, or say 5% on the 10-year bond.

That will have two effects. First, it will push the U.S. economy into renewed recession. Second, it will raise the cost of financing the Treasury. Currently, interest outlays are only 1.4% of GDP, based on debt held by the public of 72% of GDP - an interest rate of less than 2%.

If interest rates go to 5%, that cost can be expected to double, to around 3% of GDP. And that's not a good thing at all.

A Realistic Assessment

Let's assume President Barack Obama is moderately successful at holding spending in check, and that the Siren Song of more wasted "stimulus" spending when the recession hits are avoided.

We can then forecast an increase in spending of about 6% of GDP, as in 2000-03, assuming a somewhat deeper recession than that mild one but better spending control than under the spendthrift George W. Bush. Add the 1.5% of GDP from extra interest payments, and you have a total deficit increase of 7.5% of GDP, giving a 2015 or 2016 deficit of 11.5% of GDP, or about $2 trillion.

Given the oncoming train of higher Social Security and Medicare, that's enough to turn us into Greece. Debt would be increasing uncontrollably, while the politicians would be unable to bring the deficit back under control.

Add the damaging effect on the U.S. workforce of another recession that started from an unemployment rate of 14% or more, as measured by the broad U6 measure, and default on U.S. Treasuries appears as likely as not. After all, there's no Germany to bail us out.

For investors, the lesson is clear.

  • Avoid U.S. Treasuries.
  • Split a good portion of your investments between precious metals and a range of emerging markets equities.

Theoretically, emerging markets are liable to run into financial difficulties in a global downturn. But in practice, many of them (excluding the fashionable BRICs) have recently run their economies better than the U.S., and have less debt and more growth, and are therefore a better bet.

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