US debt downgrade is not news, it is "olds" - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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8 AUGUST 2011


The US has enjoyed an AAA rating from S&P since 1917.

The other two rating agencies, Moody's and Fitch, also rate the debt obligations of the US as the equivalent of AAA - the highest possible grade which denotes the lowest risk of an intent to pay and the highest ability to pay its debt obligations.

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Moody's and Fitch have not yet altered their view of the intent and ability of the US government to repay its principal and pay interest on time. On Friday, August 5th S&P moved the rating of the US down one notch from AAA to AA+ with a negative outlook suggesting that the rating of the US government could fall further.

There are now only 16 countries left in the exclusive AAA club as rated by Moody's and S&P.

Chart 1: CNN Money says 16 left with AAA rating


The intent and the ability

While downgrading the US debt, S&P made a point to highlight the recent political impasse in the US caused by the two major political parties fighting over the conditions of a further debt increase. According to S&P, the fight suggested that the intent of the US government to pay is in jeopardy. In their desire to stand stubbornly behind their point of view (no matter how right it was) the politicians in the US were ready to let the US government default on the obligations falling due on August 3. Not a good sign for a creditor.

But there is another strange aspect to the US debt situation: the level of debt and the rapid increase in debt.

According to Wikipedia, "The figure below shows the trend in public debt with the background colored by the party controlling the executive. The color of the trend line does not represent party affiliation; only the background does.

Chart 2: Time series of U.S. public debt overlaid with partisan affiliation of the White House. The upper graph shows the U.S. public debt in trillions of USD while the lower graph shows the U.S. public debt as a percentage of GDP. (Data are from the 2009 U.S. Budget.)"


The US has been the policeman for much of the free world. It spends USD 1.2 trillion or about 8% of its GDP on its far-reaching military programmes, some welcome and some unwelcome. It has obligations to look after the retirement of its ageing population - a population that is living longer but stopped contributing in any significant way to economic activity when they retired at the age of 60. The medical cost of looking after these retirees is probably increasing by some 15% per annum.

But while its obligations and responsibilities are increasing, the US is no longer able to generate wealth or annual income. It has little to export in a competitive world. The US-based multinationals use their reach to source goods from low-cost economies.

If the IMF were to look at any country with a trade deficit as large as the US and a debt obligation as large as the US, it would immediately classify such a country as "bust" and need of immediate intervention. But because this data is of the US economy and because the US Dollar has the advantage of being a global reserve currency, the IMF is silent. The US government can issue bonds to the rest of the world and continue on its path without making any changes. And the world keeps buying the US issued bonds because they know that the US would always pay back - even if by issuing more debt.

Bernie Madoff, the hedge fund manager who swindled tens of billions from his investors, recently called the US the runner of the biggest "Ponzi" scheme: a fraud.

Like they say, it takes a thief to recognise another one.

And, with the S&P downgrade, the lid may just be blown of this racket!

What next?

It is a matter of time before the US Dollar no longer remains the dominant currency. For now, there is no obvious alternative hence the US Dollar will be fine and things could drift for a while till an alternative is found. For all its growth, China has not won the trust of the world. For all its legendary stability the Swiss Franc is a pygmy. And gold is loved by many individuals - but hated by the central bankers who have tried their hardest to portray gold as some "barbarous relic".

The downward rating of the US debt should not come as a surprise at all. In fact, expect many more downgrades. But those with savings will still buy US Bonds because they have very alternatives.

These are uncertain times and the key in any uncertain time is to understand what your needs are - as an individual - and what your wealth is. The table below is a wonderful first cut for what you should be invested in - change the assumptions and the allocations to suit your needs and situation.

If Indian share prices collapse - as they did after the Lehman bankruptcy - it would be a great time to buy into India. But be aware of what you are buying and the price you pay for it.


Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
(NSE symbol: QGOLDHALF)
Quantum Liquid Fund
Why you
should own
it:
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"


Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.


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Equitymaster requests your view! Post a comment on "US debt downgrade is not news, it is "olds"". Click here!

6 Responses to "US debt downgrade is not news, it is "olds""

SHAH D.J

Aug 18, 2011

dear sir,

MR.DAYAL YOU HAVE LOST YOUR MIND LIKE WHAT DOCTORATE MANMOHANSINGH IS CLAIMING THAT BECAUSE OF USA POLICY U SUPPORTING ANNA'S MISSION ON FAST AND HIS LEARNED MP MR. RASHEED ALWI BOASTS THAT FOREIGN NATIONS ARE BEHIND CORRUPTION TO MULTI BILLION DOLLARS.LET ME TMENTION YOU THAT KALMADI WAS ALLOWED TO GO TO DUBAI EVEN AFTER COMMONWEALTH SCAM SO RASHEED ALWI IS 100% RIGHT AND HIS ANSWER IS WITH HIS MP FRIEND KALMADI LET RASHEED KNOW HE MUST ADD OTHER COUNTRIES NAMES FOR WHICH HE IS WELL AWARE WHO ARE NEIGHBORS TO INDIA.
Is the US Fed a terrorist organisation? NOT FED BUT YOUR HIDE MIND IS ON THE SIDES OF DISCRIMINATION TO GAIN YOUR COVERAGE FOR MINORITIES WHO ARE NOT REAL MINORITY BECAUSE THEY EXCEED UN RULES OF 5% TO CLAIM NON MINORITIES COMMUMITY.YOUR HONEST TRUTH OF TERRORIST FITS FOR YOU 100%

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Girish Jain

Aug 18, 2011

I read all your articles and this was the BEST one till date. You have explained the fundamental fault in Fed's approach and how their faulty approach has led to surge in gold prices. Although, terming Fed as terrorist organization was too much but that reflects strong sentiments against Fed's actions. Really appreciate this article and would strongly recommend everyone to read.

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AB

Aug 8, 2011

EquityMaster has always been a proponent of Warren Buffett. Can you please commend why Buffett is supporting the US against S&P??

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T.Chandrasekharan

Aug 8, 2011

Reg: "But those with savings will still buy US Bonds because they have very ** alternatives."

It should be very "LITTLE" alternatives. Isn't it?

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K.G. Rao

Aug 8, 2011

Reg "The table below is a wonderful first cut for what you should be invested in - change the assumptions and the allocations to suit your needs and situation.", where's the table? Not in the newsletter as transmitted.

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MZ

Aug 8, 2011

Dear Sir,

Ur views are indeed Honest truth, but also Inconsistent Truth

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