Can American Become Greece?

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Investors face four possible implications from the recent downgrade of America’s long-term credit rating by Standard & Poor’s: 1) Lower prices for financial assets; 2) Higher volatility in the asset markets; 3) Greater potential for trend-following investment strategies, and 4) Attractive opportunities in “blue chip” stocks. Those outcomes are best understood through the lens of an octogenarian investor.

Nothing makes an 85-year old man tune you out faster than the topic of long-term investing. “Don’t tell me about the long run,” he might say, “I need investments that work right now!” I can’t argue with the old-timer’s logic. I plan to invest the same way at 85, if I’m lucky enough to get there.

But what if everyone adopted the attitude of an 85-year old investor? How might financial markets evolve differently if no one framed their behavior from a longer-term perspective? What if it became rational for everyone to adopt a shorter time horizon?

The historic action taken by Standard & Poor’s last week to downgrade the long-term credit rating of the U.S. government takes us a step closer to finding out. Granted, it’s only a step. The factors that drive money into U.S. Treasury bonds remain intact for now, regardless of what S&P thinks.

Even so, a downgrade of America’s credit rating is significant. It will echo through the financial markets for many years to come by pulling forward the average time horizon investors consider when they allocate their capital. Like the 85-year old man who must factor his own mortality into his investment choices, America’s credit downgrade may remind investors of every age not to take the “long term” for granted when it comes to the relative standing of the world’s largest economy.

Those who downplay the significance of America’s damaged credit rating argue that S&P did not introduce any new information in its report, so market prices need not adjust. Maybe…but that’s the same reasoning that led people to believe home prices must be “right” five years ago because they were set by the invisible hand of an efficient market. The global economy is still paying dearly for that mistaken belief.

In the current situation, the belief being challenged is that U.S. Treasury bonds are risk-free. Standard & Poor’s says they are not. How many investors around the world might find the time to double-check their facts on this topic in the wake of S&P’s very public declaration?

If they did, what they would find is a nation whose fiscal trajectory looks eerily similar to Japan, or even Greece, about 10 years ago. For instance, the Congressional Budget Office (CBO) projects that nearly 80 million Americans will become eligible for Social Security and Medicare benefits over the next 20-years. The so called “dependency ratio,” which measures the ratio of those aged 65 and older to the working age population, will rise from 22% to 38% over the next 25 years according to the CBO. Against this background, the CBO projects that federal debt could reach 100% of GDP in 10 years; 200% in 25 years; and 300% in 35 years.

Read more articles by Keith C. Goddard, CFA