Sovereign Debt Risk Not News to Kelly Letter Subscribers

We’ve been watching this storm brew for many months, as I’ll share below. I’m currently preparing a look at where the market is now, what opportunities lie in the sell-off, and other such pertinent considerations as the global financial absurdity continues. If you’d like to join us to receive my next note on Sunday morning, please visit the subscription page.

The following excerpts are taken from last year’s Note 74, sent to subscribers on Sunday morning, December 20, 2009:

I know the tone in mass media points to an abating recession, rising stock market, and free-flowing honey, but according to a new misery index created by Moody’s, it might not materialize quite that way.

Last week, the ratings firm issued its 2010 outlook on sovereign risk. Along with it, Moody’s created a misery index designed after the ones used in the 1970s. Rather than focusing on inflation and unemployment rates, the new one uses fiscal deficits along with unemployment rates. The result is miserable, indeed, with both factors pushing the limit for dozens of nations, including Spain, Ireland, Greece, the UK, the US, France, Germany, and Italy. The US is ranked eighth most miserable, as seen in a chart of the misery index here.

Risks presented by Moody’s included a dangerous debt shadow, social upheaval, and an enormous amount of what it called “exit risk,” which is the potential for propped-up markets to buckle when government supports are removed. It pointed out that most governments are so overstretched already that the goal of waiting until 2012 to remove supports is unrealistic, and that most governments will need to take off the training wheels in 2010, too early for most markets to fare well on their own.

What’s even more frightening to Moody’s is the potential for another financial crisis and what it would do to fragile government finances. Simply, most governments cannot afford another meltdown. Governments like the UK and US are already walking the razor’s edge on their top ratings, and another crisis would send them down. That’s unthinkable, so Moody’s believes governments are already transitioning away from protecting corporate balance sheets to protecting national, or sovereign, balance sheets. It calls this ring-fencing government balance sheets, and views the Dubai World crack-up as an early indicator of how bad things can get when the government training wheels come off wobbly corporations.

The social unrest component may come from a government tendency to default on social obligations before defaulting on financial ones. Retirement ages get cranked higher, payouts dialed lower, and so on to preserve cash for debt servicing. That angers those whose benefits suffer, and many turn out onto the street in protest.

Without a doubt, the debt burden is crushing the growth out of many economies, just as it has done in Japan. An aging demographic is partly to blame, but by no means nullifies the issue. Non-financial pressures can still affect financial outcomes. If an aging population in developed countries demands more social services just as governments tighten the purse strings, that could lead to the social unrest that Moody’s fears.

The Greek debt downgrade last week may have provided a preview of things to come. Markets are up, but at what price? Government financial stability, by the looks of it, which would make the bear market rally a pyrrhic victory of historic magnitude.

Rob Burnett, head of European equities and fund manager at Neptune Investment Management, told Reuters last week, “Government spending has been the major driver of global growth in 2009 and the capital markets’ challenge to this is a concern. In Europe, Greece is the standout country but the UK, Spain, Portugal and Italy are all experiencing a similar problem. We need to see a calming in fears in relation to government debt for markets to sustainably advance.”

Such a calming looks unlikely. Moreover, there’s panic on tap as once unthinkable sovereign credit ratings downgrades are now almost expected. Citi strategist Michael Hart told Reuters, “A ratings downgrade for the UK now is increasingly likely. This may translate to a higher risk premium in the form of rising interest rates. . . . If yields exceed a certain threshold they are more likely to be interpreted as a sign of distress than as a buying opportunity.”

While the media is cocksure about the strength of the global economy, those closest to it are anything but. In fact, they’re advising precautionary measures because they know that another crisis will present two caustic options to sovereign governments: commit financial suicide by borrowing even more to bail out yet again, or refrain from bailing out and watch tax revenue dry up as the economy shrivels. Japan is doing both, in an amazing display of monetary prestidigitation. “Borrow, bail, and barf,” is the official rallying cry of government largesse distributors in Tokyo, and the fad is spreading around the planet.

This is a big risk, as Moody’s made clear. A sovereign debt sell-off in 2010 could lead to a big downturn in financial markets if central banks don’t pull off a perfect exit from their economic supports. Exhibit One is Greece, about which David Oakley wrote in Wednesday’s Financial Times: “Central banks will start their withdrawal of emergency support in earnest next year. Greece has been an early casualty, with its stocks and government bond markets having been sold off during the past few weeks amid worries that, once emergency support from the European Central Bank is removed, the economy will implode.”

What’s said of Greece today may be said of the global economy in 2010, and that could well be the catalyst that drives the market toward the big base of the S&P 500. . . .

A Societe Generale 4Q report for clients entitled “Worst-Case Debt Scenario” came with a chart showing the fiscal “inconvenient” reality that global debt has soared 250% in the last decade. It, along with many other firms and Moody’s, is worried. Just as that debt grows, income to service it via tax receipts is dropping. According to ZeroHedge, on a rolling 12-month basis in the US, individual withholding taxes have fallen nearly 8% in the last year and corporate withholding taxes are down an astonishing 64% in the same period.”

With governments in such financial pickles, no wonder citizens are in debt up to their eyeballs. It’s a culture of debt from top to bottom, with the US Treasury no less culpable than credit card crackheads at the local mall.

From the Moody’s report: “The end of exceptionally low financing conditions will expose the true cost of the crisis on government debt affordability across the world. The crisis of public finances that has beset many rich countries is the final — and disturbingly long-lasting — stage of the global crisis after the financial and subsequent economic crises.”

Maybe that’s the “very special kind of economic situation” Larry Summers spoke about. He should know; he helped engineer it.

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