More Sovereign Downgrades in the Pipeline, Defaults to Follow … What to Do!

It’s easy to get confused by the daily deluge of information. For the past several weeks, the news on global economies and financial markets has been especially volatile …

Greece was on default watch. But after ramming through more austerity promises, they were hailed to have dodged the bullet.

Then Italy was put in the line of fire. Its government bonds came under attack. And all of the sudden Spain and Italy’s vulnerability put Greece and the weak countries in the euro zone back on default watch.

After a euro-zone finance ministers’ meeting this week, the Dutch Finance Minister said a Greek default was possible. Shortly thereafter, his European counterparts said it wasn’t.

Then the focused shifted to the Fed …

In the Fed minutes, eager stock market bulls took the Fed’s discussion on the prospects for another round of QE as a done deal. What they didn’t acknowledge is that while QE3 may come at some point, it’ll take another dive in economic activity and inflation to get it!

As such, markets took another violent swing.

Over at Moody’s, they’ve been especially busy. They downgraded Greece to junk status in June. And in the past two weeks:

  They downgraded Portugal and Ireland to junk.

  They downgraded Irish government guaranteed bank debt to junk.

  They heralded an impending banking crisis in China, exposing more than half a trillion dollars of additional at-risk loans on the books of Chinese banks.

  And they warned on a downgrade of U.S. debt.

Given this backdrop, it’s no surprise that the global financial markets continue to be a turbulent ride. And as Bernanke said this week in his testimony before Congress, “uncertainty is piling up globally.”

But using history as our guide, things aren’t that uncertain. History shows us that severe financial crises, like the one we continue to work through, are generally followed by sovereign debt crises. And that’s precisely how it’s playing out.

You see …

Sovereign Debt Crises Tend to Play
Out in Four Stages (the Four D’s) …

Stage #1:
Burgeoning Deficits

In a financial crisis government spending increases dramatically in attempts to stabilize the financial system and stimulate economic activity. Tax revenues fall. Fiscal surpluses turn into deficits … and economies with existing deficits keep piling it on.

How it’s playing out …

Nearly 40 percent of world GDP comes from countries that are running deficits still hovering near 10 percent.

Stage #2:
Ballooning Debt

When economies are contracting or even growing slowly, bringing these deficits back down to earth becomes an unenviable challenge. Governments have to make ends meet by borrowing. Then those burgeoned deficits turn into growing debt loads.

How it’s playing out …

When debt reaches 80 percent of GDP threshold, the borrowing costs for governments typically starts ticking higher, and so does the market scrutiny. The IMF says five of the top seven developed countries in the world will have debt levels exceeding 100 percent of GDP in the next four years.

Stage #3:
Downgrades

S&P followed Moody’s in warning it may cut its AAA rating for the U.S.

When deficits and debts rise and economic activity appears unlikely to curtail fiscal problems, the credit worthiness of the government falls under intense scrutiny. And that’s when we see downgrades.

How it’s playing out …

Greece, Portugal and Ireland have all been downgraded to junk status. Spain has lost its AAA rating. Italy’s rating is under review. Japan was downgraded earlier this year. And with all the political maneuvering in Washington regarding the debt ceiling, the U.S. was the most recent to be warned.

Stage #4:
Defaults

This is the final stage. That’s because downgrades only make the vicious cycle of weak economic activity and growing dependence on debt worse.

When investors see more risk, they require more return. Therefore, the borrowing costs for these troubled countries rise. Then it becomes harder to finance spending needs and harder to finance existing debt. And that’s when we see defaults.

How it’s playing out …

When S&P downgraded Greece to junk status, it warned debt holders should be prepared to receive just 30 cents on the dollar. Moreover, Europe’s most recent plan in a scenario of “selective default” for Greece means private investors in Greek debt could take a 50 percent haircut.

And defaults tend to be contagious.

[Editor's note: Bryan has a video that shows how currencies can help World Currency Trader members stay safe and profit during this global unrest. To watch it, click here.]

The dominoes are already in line: Greece, Ireland, Portugal, Italy and Spain. But with all of the threats that Greece represents to the global economy, a default by other PIIGS could be even more devastating …

Italy is nearly 3 times the size of Greece, Ireland and Portugal combined. And Spain represents 12 percent of the euro-zone economy!

Of course indebtedness and economic vulnerability isn’t just a European problem, it’s global. It defines the current global economic environment — one suffering from the fallout of one of the most severe global credit bubble bursts on record.

With that, Japan, the UK and the U.S. all qualify for “default watch” too, not to mention other European countries that would be severely damaged in the case of rolling defaults and a broken currency union.

In sum, step back from the trees to see the forest, and you’ll get a valuable perspective on the investment landscape. We should expect this global economic fragility to continue and for the final stage of the “four D’s,” associated with historical sovereign debt crises to play out.

In 2007-2008, a private debt crisis led to a massive capital flight from all relatively-risky assets. Expect the same again in this public debt crisis. And from an investor’s standpoint, it’s not a beauty contest, but a “least ugly” contest as this global crisis spreads.

Regards,

Bryan