Prepare for the Downgrade

Addison Wiggin – August 1, 2011

  • Debt deal done: Rally on! Manufacturing numbers tank: Rally off!
  • Looking beyond the debt deal: Dan Amoss, Adrian Day on what to expect when the downgrade comes
  • Four Vancouver experts on how much longer the commodity bull has to run… and which sectors are still cheap
  • Man ties up federal courts over a 75-cent newspaper (but you might be able to cash in)

   So much for the relief rally.

After all the hand-wringing, grandstanding and political showmanship this past week over the debt ceiling, you’d think the Dow would be more grateful than the 145 pop it gave on the open this morning.

Alas, immediately following the open… it sank. As we write, it’s down 45 points.

   The culprit? The ISM manufacturing survey tumbled in July from 55.3 to 50.9 — a two-year low.

To say the number violated the Street’s expectations is, um, an understatement: Among 80 economists polled by Bloomberg, the lowest guess was 52.0. Every component of the index indicated slowing growth… and new orders fell into outright contraction.

Whether Congress votes on this deal to raise the debt ceiling or not… there’s plenty of real concerns in the economy to give stock traders the willies.

   Likewise, commodities traders are feeling a chilly wind. Manufacturing in China slowed for the fourth straight month.

The June figure of 50.9 fell to 50.7 in July, according to the China Federation of Logistics and Purchasing (FLP), the ISM’s counterpart in the Middle Kingdom.

Within the FLP report new orders look promising… mostly chalked up to domestic demand, not exports. But a separate unofficial gauge of Chinese manufacturing issued by HSBC slipped into negative territory.

Given comments we heard during the symposium last week, we expect an “official” decline in Chinese manufacturing… which, as we noted a few days ago, would drive down prices for the 11 commodities of which China is the largest consumer.

   We’ll spare you play by play on the bipartisan deal making its way to the floor of both houses for a vote, possibly tonight. But here are a few cogent plotlines:

  • The $2.5 trillion in spending cuts are, in the immutable logic of Washington, not cutbacks at all… but limits to the planned rate of spending increases
  • Even better, they don’t don’t kick in until 2013. At that time, a new Congress will be in place, unbound by the promises of the current one.

There’s also a “last minute” mechanism by which $1 trillion of the “cuts” are to be specified now, while the remaining $1.5 trillion — including Social Security and Medicare fixes — are to be hashed out by a special 12-member congressional committee.

It gets better.

The committee will issue its recommendations by Nov. 23 — the day before Thanksgiving. Congress would then vote on the recommendations by Dec. 23 — the Friday before Christmas.

Even if this deal gets the votes it needs, the White House and Congress have done their best to give the can a good swift boot… but made only a glancing impact. The can will have barely moved.

   Now the rating agencies face another challenge to their credibility. The big three have spent the last several weeks threatening to downgrade Uncle Sam’s AAA bond rating unless the deal actually gets spiraling debts and deficits under control.

“$4 trillion would be a good down payment,” said John Chambers, the head of S&P’s sovereign ratings committee. The number in the proposed agreement is $2.5 trillion.
We daresay that if S&P wants to continue to attract business… it will have to follow through on its threat.

   “Eventually, there’s a downgrade coming,” Pimco’s Bill Gross said yesterday. “It just depends on Moody’s, S&P and Fitch, and they’re very slow-moving. This country has $10-12 trillion worth of outstanding debt. In addition, however, we’ve got about $60 trillion worth of liabilities.

“I call this Debt Man Walking.”

   “A downgrade from AAA is a matter of when, not if,” writes our short strategist Dan Amoss. “In it’s wake, the dollar index will fall and gold prices will explode on the upside. Such a downgrade would speed up a slow-moving process that has long been under way: the loss of the U.S. dollar’s role as the primary reserve asset for central banks.

“Even the most radical forecasts are off base.”

“The Fed will have to ensure that there is no liquidity squeeze — perhaps even reopen the commercial paper funding facility it started after the Reserve Primary Fund ‘broke the buck’ in 2008.”

“In short, foreign creditors should accelerate their diversification out of Treasuries and into tangible assets when even the slowest money starts realizing that the positive attributes of the Treasury market — liquidity — are far outweighed by the negatives — never getting repaid in honest money.”

   Of the $2.2 trillion in revenue the Treasury pulls in each year, about 10% is going for debt service.

“We’ve had higher numbers before,” said veteran analyst Adrian Day on Friday during our symposium in Vancouver. “But rates are now at 70-year lows. And more of the new debt Treasury is issuing these days is of short duration… because those rates are lower.”

Just a reversion to “normal” interest rates… never mind a downgrade… would quickly drive up debt service to 30% of revenue.

This is a reality foreigners already recognize… which is why they’re buying fewer U.S. Treasuries. China’s Dagong rating agency gives its top ratings to Norway, Denmark, Luxembourg, Switzerland and Singapore. Among the world’s nations, Dagong ranks the United States No. 13.

If foreigners got serious about fleeing Treasuries, the heavy lifting would fall once again to the Federal Reserve. As yet, the Fed has already bought up 80% of Treasury debt issued in 2011.

“There’s something dramatically wrong when one arm of the government is creating money to buy the debt of another arm of the government.”

Amen, Mr. Day.

   “This whole wrenching effort to shrink the debt may actually increase the debt,” explained an AP story anticipating a downgrade.

A downgrade “could increase the cost of borrowing for the government — hence more interest and debt — not to mention for everyone else.” Not the least of which are state and local governments who received 80% of the last round of stimulus… we spell out those dramatic consequences here.

   Gold has gyrated since the open of the spot market last night, but at last check, it’s $1,625 — only a couple of bucks off the all-time high reached on Friday. Silver, which pushed above $40 on Friday, is back to $39.59.

   Despite early concerns over a slump in China, the CRB — a broad index of commodities — is up today to 345, on the high end of the range it has been trading at for the last three months. And at $4.41, a pound of copper is only a few pennies off a three-month high reached last week.

After touching $100 briefly again last week, only to pull back, crude is up 70 cents this morning, to $96.41.

   “We haven’t even recovered to where we were in 2008,” said Resource Trader Alert’s Alan Knuckman, when it comes to the long-term outlook for commodities. “There’s still a long way to go.”

Alan took part in a fast-paced and freewheeling panel discussion on the final day of our symposium Friday… and on this point everyone was in agreement.

“We’re at a unique point in time,” said newsletter editor Brent Cook, a geologist who used to check out mine sites for Rick Rule’s firm. “We cannot physically keep up with demand for the metals.

“We’re a third of the way” into a long-term commodity bull, added David Franklin, the chief of Sprott Private Wealth. “China and India have just gotten started.”

“Imagine,” added Brazilian offshore oil pioneer Marcio Mello, “your average Chinese citizen going from two eggs a week to 10!”

“This unanimity of opinion scares me,” said panel moderator Rick Rule, his contrarian pulses always on a hair trigger.

   What’s still cheap in the commodity space? Among the answers: Natural gas, platinum, water and uranium.

“For the first time since 1997,” said Matt Badiali, “more rigs are drilling for oil in the U.S. than for gas. Natural gas has immense potential.”

After the round table, Messrs. Badiali, Cook, Franklin and Rule later met with smaller groups to identify their favorite resource names. By a rough count, there were probably two dozen to pick from.

That’s in addition to the favorites highlighted by our own editors in every sphere from resources to biotech. You can get the name and ticker symbol of every one in a handy report we’ll be issuing toward the end of this week. That’s in addition to the audio recordings of all the sessions in the main hall.

You can have this entire package in your email inbox by the end of the week. And if you move on it before midnight tomorrow, you’ll still secure the best available price.

   One of the staples of business travel has turned into a federal case… and a poster child for the kind of litigation that threatens the wheels of commerce in the U.S.

Rodney Harmon stayed at a Hilton Garden Inn in Santa Rosa, Calif. last March. As you no doubt have experienced, Rodney opened his door and found a copy of USA Today left in front of his door.

Mr. Harmon checked his bill and discovered he’d been charged 75 cents for the paper.

Like any sane man, he asked to have the charge removed. Oh wait, no he didn’t. He sued the hotel in federal court in San Francisco.

Once a minor annoyance, now a federal case

“He did not request a newspaper and assumed it had been placed there by hotel staff,” reads the suit, filed in U.S. District Court in San Francisco, which further explains the fee was hidden in “extremely small font which is difficult to notice or read” on the sleeve of the room card.

As if to make frivolous litigation even more frivolous, the suit notes the “offensive waste of precious resources and energy,” explaining that “deforestation caused by paper production is a matter of concern and worry in this state, country and worldwide.” How exactly this harmed Mr. Harmon the suit does not say.

But he’s seeking class action… on behalf of as many as 7 million people. Damages sought? He doesn’t even specify. That’ll be worked out later.

Good grief.

   “Doug Casey,” says a reader who caught our reports from Vancouver last week, “says the fools in Washington can’t even identify the enemy in the ‘War on Terrorism.’”

“So they made all of us ‘enemies’… as anyone flying discovers.”

The 5: We’re just getting back from Vancouver. The symposium was easily the best one we’ve hosted to date. Thank you for attending, if you were there. And putting up with quickly assembled editions of The 5 if you weren’t. We should be back on track tomorrow!


Addison Wiggin
Agora Financial’s 5 Min. Forecast

P.S.“Surrealism is the perfect metaphor for the era we’re living in,” writes our colleague Jim Amrhein, inspired by the images we witnessed Thursday night at the Vancouver Art Gallery, part of a special event limited to Reserve members during last week’s symposium.

“As I walk pensively among the bird-headed men and bent spoons and truncated pornographic torsos and grotesque hodge-podges of disparate objects combined into single pieces that seem like the aborted fetuses of bad dreams, I figure out exactly what it is” that holds a strange attraction.

“Surrealism is nightmarish — like many western-world economies, especially the United States. I thought I already knew how bad that dream was…”

“Then I came to the 2011 Agora Financial Investment Symposium.”

You can read the last of Jim’s entertaining and enlightening dispatches from our gathering last week at this link.


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