Where to Turn When the Dollar Falls
04/22/2011 9:00 am EST
Credit-rating agencies are more worried than ever about America's fiscal health. Now it's time for you to act as your own credit rating agency. Here are 4 categories to help you invest abroad.
Why should Standard & Poor's have all the fun?
On April 19, the credit rating firm shook global financial markets by putting US 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 an AAA? Brazil? Columbia? Germany? How do they stack up?
It's time to become your own credit rating company and fill in the gaps left by recent headlines.
You should make up your own list of good credits and bad credits so 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 Standard & Poor's, 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 care much about this kind of static rating at all. What you want to know is the direction in which a county's debt rating is heading. For that, I want to introduce you to my own version of a bucket list—which is more than good enough as a place to start.
It's certainly enough so that you figure out what currencies you'd like to be holding in your stock portfolio ten years from now. (Think the US dollar is going to hold its value over that period?)
My system requires just four big buckets. Let's start from the top.
NEXT: The Good Buckets|pagebreak|
Bucket No. 1: The Hardest Club in the World to Get Into
This bucket is reserved for the countries with 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 Norway or Chile runs its budget and economy.
A tough, hypervigilant central bank that manages 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 ten times in 11 months, to 4.5%.
The most recent increase of 0.5 percentage points in April came just weeks after a similar 0.5 percentage point increase in March. Inflation isn't going to get out of control in Chile's economy if the central bank can help it—and inflation was just 3.5% in March, mind you.
But a central bank as tough as Chile's isn't enough. You also have to have a political consensus that the country needs to live within its means—both now and over the long run. Both Chile and Norway believe in putting money away during boom times for the inevitable busts that are part of the cycle.
Chile, despite its efforts to diversify, is a commodity economy dependent on copper. In past decades, the country has spent at the top of a cycle like the boom would last forever, only to be left with nothing in the bank when copper prices inevitably sank.
In an effort to end that boom-and-bust trap, the country set up two independent panels of experts who decide when the country can run a deficit. According to the panels' rules, 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 ten-year equilibrium price.
This system actually works. In the boom of 2003-2008, the government wanted to increase spending because, it argued, the increase in the price of copper was permanent. The panels said no. 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 been able to tap its Economic Stabilization Fund, put away in sunny days, to finance $8 billion in extra spending, which helped limit the contraction of its economy in 2009 to 1.5%.
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 time when production inevitably begins to fall.
This way, the country doesn't get accustomed to living on what is a temporary cash flow, thus dodging the dangers such an approach would pose for asset bubbles and wasteful spending. Norway's sovereign wealth fund is now the second largest in the world—$548 billion as of the end of 2010.
As I said, membership in this first bucket is rather limited. I'd also 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. And I'd argue that Chile’s A+, the highest rating in Latin America, is underrated.)
Bucket No. 2: Countries with Manageable Fiscal Problems
Countries in this group do a good, 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 countries: Germany, Canada, and Australia.
They're not perfect. Australia and Canada, for example, have commodity-based economies, and haven't yet developed anything nearly as effective as the countercyclical measures of Norway and Chile.
Germany has a regional banking problem—the Landesbanks—that it refuses to face up to. A good number of these banks are overexposed 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 (my first bucket is just plain out of reach for most). Problems in this bucket are manageable—Germany's gross debt is just 80% of GDP, not the 229% of Japan—and in the long term, problems are of a dimension that politicians probably can master.
For your own long-term fiscal health, you want to make sure your portfolio has a healthy dose of assets from these economies. Australian mining stocks such as BHP Billiton (BHP) or Macarthur Coal (MACDY in New York; it's MCC.AU in Sydney), for instance, or bank stocks such as Australia's Westpac Banking (WBK) or the Bank of Nova Scotia (BNS) in Canada are some good options.
NEXT: The Flag-Raising Buckets|pagebreak|
Bucket No. 3: The Credit Quality 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 No. 2, or down to join the wastrels of Bucket No. 4.
In this bucket, I'd put Brazil, Colombia, and Indonesia. 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 subsidies on gasoline and kerosene to dampen political opposition—could derail Indonesia's 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 fall, by the end of 2011 or the beginning of 2012. But with commodity prices continuing to climb, and signs of a credit bubble emerging, I wouldn't say it's certain this developing economy will move up.
The countries that might be headed for a downgrade also go in this bucket. The United States obviously belongs here. And 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 would also face downgrades.
How is the United States not AAA, but the United Kingdom is? France, with its huge labor and pension problems, is also AAA? Mexico? Our southern neighbor is hovering on the edge of a budget crisis caused by falling oil revenue and is rated just one grade above junk-bond status by S&P.
China goes in this bucket, too. There's quite a difference of opinion on China's financial condition, you see:
- On 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. Today, 15% of all loans in China are bad, and the number 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 to enable you to maximize exposure to the countries that are headed up, and minimize exposure to those headed down. Not in the short run, mind you, but certainly over the long term.
Your judgment on what direction a specific country's credit rating is headed shouldn't be the sole reason you buy or sell a stock. But it is one factor blowing in a stock market's direction—or against it.
Bucket No. 4: The Deeply Damaged
Here you'll find the countries that don't seem 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—then climb out and fall back in again. Mexico earned its current investment-grade rating, which it's now in danger of losing, 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 it also has to convince the ratings companies that the fix is 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 thus the stocks and bonds priced in it. On the other hand, an improving credit rating can push up stock and bond prices and be reflected in a rising currency.
By itself, a national credit rating downgrade isn't enough to sink a stock, 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Macarthur Coal and Westpac Banking as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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