One of the most interesting and potentially disruptive technological innovations of the digital age ...
Be your own S&P: Here's how to rate the debt of all the world's countries (and then use your ratings to guide your portfolio)
04/22/2011 8:30 am EST
On April 19 S&P shook global financial markets by putting U.S. government debt on negative credit watch. If the United States doesn’t get its budget act together, S&P warned, it would take away the country’s AAA credit rating.
But why stop there? What about Japan? Does a country with a gross public debt of 229% of GDP deserve an AA- rating? The United Kingdom at AAA? Brazil? Colombia? Germany? How do they stack up?
It’s time to become your own credit rating company and to fill in the gaps left by yesterday’s headlines.
Yep, you should make up your own list of good credits and bad credits so that you can figure out how to allocate your portfolio. Downgrades and upgrades are going to come faster than an avalanche moves downhill. And you’d like to be on the right side of those moves.
Seem too hard? Well, it would be a daunting task if your ratings had to include the detail that S&P, or Moody’s or Fitch Ratings do. But for your portfolio purposes, you don’t really care about the differences between AA+ (Belgium according to S&P) and AA (Spain). Actually you don’t are much about this kind of static rating at all. What you want to know if what direction a county’s debt rating is head in—and for that what I call Jim’s Bucket List is a more than good enough place to start.
It’s certainly enough so that you figure out what currencies you’d like to be holding in your stock portfolio 10 years from now. (Think the U.S. dollar is going to hold its value over that period?)
My system requires just four big buckets. Let’s start with the top bucket.
No. 1: A bucket almost nobody gets into. This bucket includes only the best-run fiscal policies in the world. And it’s not very crowded. To get in, all a country has to do is match the way that Norway and Chile run their budgets and economies.
A tough and hyper-vigilant central bank managing a national currency to match the changing demands of just one economy is a must. Chile’s central bank, for example, has raised interest rates 10 times in 11 months to 4.5%. The most recent increase, 0.5 percentage points in April, came just weeks after a 0.5 percentage point increase in March. Inflation isn’t going to get out of control in this economy if the central bank can help it—and mind you inflation was just 3.5% in March.
But a central bank as tough as Chile’s isn’t enough. You have to have a political consensus that the country needs to live within its means—over the long run. So both Chile and Norway believe in putting money away during boom times for the inevitable busts that are part of the cycle.
Chile, for example, despite efforts to diversify, is a commodity economy dependent on copper. In past decades that’s meant that the country spent like the boom would last forever at the top of the cycle and then had nothing in the bank when copper prices sank. In an effort to end that boom and bust the country set up two independent panels of experts who have to rule on when the country can run a deficit. According to the rule, the government can run a deficit only when output falls short of the economy’s potential in a recession or when the price of copper falls below its 10-year equilibrium price. And this system actually works. In the boom of 2003-2008 the government want to increase spending because, it argued, the increase in the price of copper was permanent. The panels said no and as a consequence Chile went into the global financial crisis with government liquid assets three times greater than the market value of government debt. The country has able to tap its Economic Stabilization Fund, put away in sunny days, to finance $8 billion in extra spending that helped limit the contraction of the economy to 1.5% in 2009.
Norway’s sovereign wealth fund works in the same way but over a longer-time period. The fund is designed to take some of the money from the boom years of Norway’s offshore oil production and invest it for the day when oil production inevitably begins to fall. That way the country doesn’t get accustomed to living on what is a temporary cash flow with all the dangers that poses for asset bubbles and wasteful spending. Norway’s sovereign wealth fund is, at $548 billion at the end of 2010, the second largest in the world.
Membership in this bucket is rather limited. I’d include Singapore and… Well, I can’t think of anyone else. (Norway, by the way has one of the world’s seven AAA credit ratings. Chile at A+, the highest rating in Latin America, is underrated, I’d argue.)
No. 2: A bucket for the ordinarily virtuous. Countries in this group do a good job but not perfect job of managing their budgets and long-term fiscal policy. In this bucket you’ll find three more of S&P’s AAA rated countries, Germany, Canada, and Australia. They’re not perfect. Australia and Canada, for example, are commodity-economies that haven’t yet developed anything nearly as effective as the counter-cyclical measures of Norway and Chile. Germany has a regional banking problem—the Landesbanks—that it just refuses to face up to. A good number of these banks are over-exposed to the debt of Portugal and Greece and their capital base is in many cases built on stuff that looks like equity capital but isn’t.
But for all real world purposes this is the bucket that countries aspire to. (Bucket #1 is out of reach.) Problems in this bucket are manageable—Germany’s gross debt is just 80% of GDP and not the 229% of Japan—and in the long-term problems are of a dimension that real-life politicians can probably master.
For your own long-term fiscal health you want to make sure that your portfolio has a good healthy dose of assets from these economies. Australian mining stocks such as BHP Billiton (BHP) or Macarthur Coal (MACDY in New York or MCC.AU in Sydney), for instance, or Australian bank stocks such as Westpac (WBK) or Canadian banks such as the Bank of Nova Scotia (BNS).
No. 3: The waiting room. For an investor this is the most interesting, useful, and potentially profitable bucket. Countries in this bucket are either headed up to join reasonably prudent countries of Bucket #2 or down to join the wastrels of Bucket #4.
In this bucket, for example, I’d put Brazil, Colombia, and Indonesia. All these countries are candidates for an upgrade from the official credit rating companies because they’re showing better budget discipline, their central banks have developed into credible inflation fighters, and their economies have picked up speed. But they are by no means certain to get those rating upgrades any time soon. Higher oil prices—and the temptation to use gasoline and kerosene price subsidies to damp political opposition—could derail Indonesia’s government budget and economy. I think the central bank in Brazil has acted with enough speed in raising interest rates that inflation will be under control, if not actually falling, by the end of 2011 or the beginning of 2012. But with commodity prices continuing to climb and with signs of a credit bubble in Brazil, I wouldn’t say it’s certain that Brazil will move up.
In this bucket also go countries that might be headed in the other direction, for a downgrade. The United States, obviously. But I think there’s a good chance that a downgrade to the United States would set off a chain reaction in which other countries that are now clinging to their current AA or AAA credit ratings only on reputation would get downgraded. If the United States isn’t AAA, the United Kingdom is? France with its huge labor and pension problems is AAA? Mexico, which hovers on the edge of a budget crisis caused by falling oil revenue. Mexico is rated just one grade above junk bond status by S&P.
China goes in this bucket too. You see there’s quite a difference of opinion on China’s financial condition.
So on the one hand, in December 2010 S&P upgraded China’s credit rating to AA- (the same as Japan’s) from A+. S&P cited China’s huge foreign exchange reserves—now estimated at $3 trillion as one reason for the upgrade.
On the other hand, on April 12 Fitch Ratings downgraded its outlook on China to negative from stable. Bad loans at China’s banks continue to increase, especially, Fitch noted, if you include off-balance sheet bank loans. Bad loans, now at 15% of all loans, could climb to 30% within three years.
China, at least according to these two rating companies, could go either way.
The point for investors in creating this bucket is enable you to then maximize exposure to those countries headed up and minimize exposure to those countries headed down. Not in the short run, mind you. But over the long-term certainly. Your judgment on what direction a specific country’s credit rated is headed won’t be the sole reason you buy or sell a stock. But it is one more factor either blowing in a stock market’s direction or against it.
No. 4: The bucket of the deeply damaged. Here you’ll find countries that don’t seem to be able to reverse their decline. For example, even a year of 7% growth hasn’t pulled Argentina up to investment grade. S&P upgraded Argentina to a B rating in September but that still labels the country’s debt as junk. Nigeria at B+ is a long way from investment grade despite its huge oil wealth.
Countries can drop into this pit from Bucket No. 3 and then climb out—and then fall back in again. Mexico earned the investment grade rating that’s now in danger in the early years of this decade. But the process of climbing out of this bucket is a lengthy one. Not only does a country need to reverse damaging policies but also it has to convince the ratings companies that the fix is for real. And like the Wall Street analysts who cover individual companies, no credit rating analyst wants to get too far ahead of the consensus.
All this matters if you’re a long-term investor trying to protect the value of a portfolio over the course of decade or more. A slide in a credit rating can help erode the value of a currency and the stocks and bonds priced in it. An improving credit rating can push up stock and bond prices and be reflected in a rising currency too.
By itself a national credit rating isn’t enough to sink an investment but it sure can make it harder to beat or even keep up with the market.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. At the end of March the fund owned shares of Macarthur Coal and Westpac Banking. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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