Why does the S&P, when in a certain stage, go down when there is good economic news because the interest rates go up when there is good news, and stocks are valued as an infinite stream of discounted earnings so the interest rate is more important because it is compounded recurringly while the effect of output is ephemeral as everyone knows. I believe that the reason that stocks go down on the rating announcements is it impacts the desire of everyone to hold risky things during uncertain times, but the more that the ratings are cut back, the greater the chances that a deal to cut spending will be made and this is good for interest rates.

Rocky Humbert responds:

I'm probably being dense, but I still don't follow your logic. You first sentence doesn't address my point about what's happening in the PIIGS right now — sovereigns are being shut out of the bond market, but blue chip borrowers are conducting business (pretty much) as usual. The rising sovereign interest rate seemingly is becoming less and less relevant to the conduct of business to business lending. In pointing out this 7-sigma phenomenon in a private correspondence with a very knowledgeable spec this morning — that this is a a very different world than we've seen for the past 40 years — the spec replied, "[This is closer to ]the world that JP Morgan inhabited, where sovereign credits were more risky than sound companies and the banks bailed out the Treasuries. I grasp what you mean in the context of not-owning-risky assets when things seem uncertain. However, this is a mindbending paradox. The risk is arising from the riskless asset. So if the riskless asset is becoming more risky, does it follow that the risky assets are proportionally more risky? Because if you sell the risky asset because you're scared of the riskless asset, do you buy the riskless asset even though it's becoming risky even though it's what made you sell the risky asset to begin with??? Off to the gym… 

George Parkanyi adds: 

Corporations (at least the true going concerns that serve a broad economic need) seem to have the resiliency of cockroaches (e.g. the Japanese and German companies that survived the massive bombing in WWII being case in point). Companies have more flexibility than governments (in general) to adapt to changing economic environments. They can more quickly re-deploy capital and can cut costs more quickly and aggressively.

It has occurred to me that if sovereign debt, massive amounts of which are out there, eventually are widely perceived as crap, there could be a veritable stampede out of it - especially in conjunction with declining currency and/or inflation. So where is that money to go? The first look would probably be commodities - especially precious metals, and the initial panicky inflows will likely drive up prices dramatically. We've seen some of this already, facilitated by the advent and growth of commodity ETFs. By the same token, there are legions of equity ETFs, funds and well-run companies which will be perceived as a safer than sovereign debt because of the survivability advantages of corporations. As commodities soar, equities will start to look like screaming bargains in comparison. Dividend-paying big-caps may very well become the new bonds from an institutional investor's perspective. This transfer of capital from debt to equity could drive stocks much higher as well in a boom similar to what commodities are experiencing. Interest rates may not matter. At high stock prices, companies will be able to raise capital through equity offerings, and dividends may come into vogue as another way to attract that outflow from bonds. As bonds are being sold, they may get to the point where they are so low that governments (that still wish to avoid default) may start buying them back on the cheap to retire them. If you had a trillion in debt that just got marked down to $500B, and you had that money and/or could print some to fund the buy-back, wouldn't you take that opportunity to wipe the $500B off your balance sheet and improve your credit rating?

Now that I think about it, jacking up interest rates to short your own debt (to buy back later) could be one bizarre option the Fed could try at some point. Although you'd likely strengthen your currency doing that and it could backfire … unless … you short the other guy's currency first … and use those profits to buy back your debt. You could probably do this once. 

Interesting times indeed. Rocky's PIIGS observations are very well worth thinking about.

Paolo Pezzutti adds:

As a country defaults I do not expect to see all companies go bankrupt. The financial health of a government does not imply that companies cannot make a profit. In a sell off type of environment where asset managers weigh down their portfolio in a troubled country, I agree you can find good bargains. One problem may be the timing. When in 2008 prices plunged I started to buy stocks of very solid companies in Italy. Unfortunately prices continued to the downside some tens of percent. It took more than a year to see prices go back to my level. during a panic also good quality stuff can sink. In Italy there are some of these companies. I look at the utilities sector,luxury, oil. I look also at banks. Most of them are well managed and are mispriced right now. But we'll probably could buy at much lower prices. Imagine what could happen in these troubled countries in case of a slow down of the global economy.





Speak your mind

2 Comments so far

  1. Tom on July 19, 2011 5:54 am

    Mr Humbert you wrote:
    I grasp what you mean in the context of not-owning-risky assets when things seem uncertain. However, this is a mindbending paradox. The risk is arising from the riskless asset. So if the riskless asset is becoming more risky, does it follow that the risky assets are proportionally more risky? Because if you sell the risky asset because you’re scared of the riskless asset, do you buy the riskless asset even though it’s becoming risky even though it’s what made you sell the risky asset to begin with???

    I think this is an interesting case. What should be is not what we are familiar with over the last several decades, so when what is logical actually presents itself we see it as the opposite.

    Soverign debt should be perceived as more risky than corporate debt, and the flight to quality should go the other way. However due to the willingness of the state to stand as lender of last resort to bust companies, bailing out the bondholders if no the stockholders, we start to perceive government bonds as being the safest option. This suits the state as it tilts the balance of power in their favour in addition to receiving better borrowing rates for itself.

    I see private capital as the only substantial challenge to state power and as such the only substantial guard of our freedoms. Ayn Rand is popular here. If we believe in the philosophy of objectivism, we believe that money is pure and will not permit a society to survive as half capital, half loot.

    With corporate debt, we have an open and honest free market transaction where we may agree to loan money to a company - and we can see how that company does business, which markets it operates in, cash flow, balance sheets, and who the directors are. When we (lenders collectively) agree with the corporate borrower on quantity, rate, and terms, a bargain is struck. We know what backs the company, we have information, the company is an honest trader - and we can make an honest bargain.

    With sovereign debt, the only asset is force. We are lending based on the ability of the state to confiscate wealth from producers at the point of a gun. Why should this be considered more credit worthy than an honest trading business? It should be that the governed periodically bail out the government as there is as of yet no perfect form of government however we have chosen to prefer government to anarchy. The manner of the corporates bailing out the treasuries as in Morgan’s time - this is the wisest and most productive men choosing the manner and form of the government bailout, and perhaps having the influence to correct the mistakes of the insolvent government.

    It should not be that the government bails out companies - companies should be allowed to fail. The model of freedom is the productive paying for a government, and freedom begins with a truly free market. The opposite is a government which confiscates property by force and gives it out to inefficient operations due to graft, cronyism, and pull.

    Now that the sustainability of the exiting government model is becoming more apparent, can we not challenge our beliefs as a society? When more begin to realise what is obvious and logical, should it not be the case that honest businesses are the “less risky” option, and the government should be charged more for its borrowings. We should demand more interest as government is known to be inefficient and make poor economic decisions which needs a bailout from the productive. Perhaps if there were enough objectivist financiers, the rates would favour production over force. Raising the rates on sovereign borrowing would force the state to keep a more balanced book also.

    Thoughts? I welcome this change as it is a triumph of substance over style. We need to correctly evaluate what provides value in our economy, and price it correctly. I suspect this paradigm shift will present very interesting speculative opportunities. We will all ultimately realise that the value is in the tangible and the creative, not the intangible sacred cows.

  2. douglas roberts dimick on July 23, 2011 9:28 pm

    Between The Rock and Tom’s Place

    As I come from a rules-based orientation, assessment of financial (or fiscal or monetary) risks a la public versus private debt – as sketched in the commentaries here – appears sensible but for two conditions precedent that make the Chair’s query limited to speculative ballyhoo.

    1. Governments not banks or corporations grant and regulate markets as well as license those very same (commercial and investment banking) institutions as so proffered by Tom, whereby “government is known to be inefficient and make poor economic decisions which needs a bailout from the productive.” The US Government’s recent bailout of the entire US financial system — yet to resolve some $75 trillion of toxic derivative debt — is a rather prima facie case on point.

    2. Although some MCN’s like to think that they can do so, governments still remain the most effective and efficient entities when it comes to planning, financing, and prosecuting war; the net effect of such sovereign action, when so intended, may quickly and resolutely alter if not workout previously upsetting (balance sheet) issues to include trade deficits and currency valuations. Case in point: at the past twenty- year $85 billion annual pace of US financed military operations in the Middle East, the federal government has maxed OCM (or other countries’ monies) “contributions” with Madoff-like efficiency.

    I called up the GBPUSD on my Tradestation screen for the past 20 years. About 1.70 then and 1.60 now; nearly par, ya? Interesting given the EURO coming onto the scene.

    It is a wonderful world where allies and trade balances remain manageable when not in line. That said…

    Then there is the USDJPY… about 136 then and 78 now. Weren’t the Jim Rogers of the world a little before back then saying how the Japanese were gonna own America – just before a new sheriff came to town and signed a tax act the nuked the entire Japanese economy?

    Aren’t the Jim Rogers of today now saying the same thing about China?

    I have been teaching, consulting, travelling, and living in China for 5 years now. For me to argue that the Randian examples ( as cited among the commentaries herein that objectively equivocate lines of financial statements with the point of a gun) are, well, never mind…

    Come see for yourselves. Money is nothing more than points on a scoreboard – as GG reiterates, I believe, in both Wall Streets.

    Here, the bankers, brokers, speculators, masters of the universe, mom and pop: they all take orders from one group – the Communists. Note that they (the Communists) are also the only ones with guns, maintaining an army loyally committed (in PLA fashion) to the omnipresence of that dictatorial regime. Everyone lives in fear (and those at the top for the greed) of it.

    You got a balance sheet problem with a provincial government or the central government? Make it disappear or maybe you (or your company) will…

    Is the execution (notably abroad) of US fiscal and monetary policy so different?

    Granted, we are not the only ones with guns. But we do have the most, and they are the biggest.

    Here the top-down government is financed by a combination of US-EU foreign currency reserves and one of the world’s highest (largely nontransparent) tax/fee-rate structures… the latter being a benefit from the efficiencies of not having to worry too much (since Clinton-Bush-Obama) about human rights and citizenship franchise. This fact is not a shining beacon on the hill for Randites, as they seem to falter when it comes to fairness and recourse issues on the playing (or battle) field.

    So where’s the risk here?

    Show it to me on a balance sheet or financial report… You won’t find it.

    And there (not seeing it) is the risk – and it’s systemic.

    As I understand it to be reported, when asked where is all that ‘that money” for all those banks and companies a la the bailouts, Bennie (or Bernie?) of the Jets retorted, “actually, it is created by pushing some buttons on a computer.”

    Well, OK, there you go… like pulling a trigger…



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