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BEING STREET SMART

by Sy Harding 

Foolishly On The Brink! July 15, 2011.

Governments around the world are struggling with record debt. The debt crisis in Europe and the struggle in Washington to raise the U.S. debt ceiling are in the news every day.

As the original debt crisis in Europe migrated from Greece to Ireland, to Portugal, to Italy over the last 18 months a commonality became obvious. Opposing government parties in each country fought over the methods to tackle the problem until each crisis reached the brink of default on the country’s debt, and confidence in its economy was in shambles.

Over the past week it’s been Italy’s turn. The third largest economy in Europe and deemed to be too large to bail out, Italy’s government has been debating angrily for months about how best to handle its growing debt crisis. It was only after the bottom fell out of Greece’s stock and bond markets early this week that the wrangling Greek parliament panicked and quickly ‘fast-tracked’ an agreement on austerity measures to at least postpone the crisis for awhile.

For 18 months now global stock, bond, and currency markets have been roiled each time the European debt crisis popped up again. And each time, euro-zone finance ministers and politicians took action only when the markets forced them to do so.

Is the U.S. now in its Greek-Italian phase? Will it take a U.S. market meltdown to convince Washington of the seriousness of the situation?

Here we are, after months of squabbling, with the drop-dead date of August 2 for raising the debt ceiling only two weeks away. This week both Moody’s and Standard & Poor’s put U.S. debt on ‘credit watch’ for a possible down-grade from its coveted triple-A credit rating, due to the lack of progress in Washington. If it were to take place it would be the first downgrade of U.S. debt since ratings began in 1917.

The most likely scenario is a last-minute, cobbled together agreement that neither side likes, which could be announced at any time, perhaps even by the time you read this.

However, the risk of a downgrade is there. Standard & Poor’s puts the odds at 50%.

As Bloomberg News puts it, “Both the Republicans wanting to replace President Obama, and Democrats seeking the best way to re-elect him, have emerged as obstacles to agreement on raising the government’s debt limit. Republican presidential candidates and Democratic activists alike are using the debate to sharpen their political messages and appeal to core voters. . . both parties set in concrete on what they believe their base has to have.”

Damage has already been done, by creating a global impression that the world’s largest economy, which professes to still be a shining example for the rest of the world, is as inept as the most backward banana-republic in dealing with problems in a rational way.

It’s particularly frustrating with the economic recovery stalling again, to see Washington still so selfishly playing party politics, taking the country’s future so close to the brink of the unknown. Experts around the world are warning that the consequences of even a brief ‘technical default’ by the U.S. are dangerously unknown, and at the least could seriously affect confidence in U.S. debt and the dollar for some time to come.

Meanwhile, the Federal Reserve and Wall Street are assuring us that the economic slowdown in the first half of the year was temporary, that the current quarter and second half will see a robust recovery.

But the economic reports continue to get worse, and the conditions causing the worsening numbers continue to deteriorate. Last week’s terrible jobs report for June should have left no doubt that the slowdown will continue this month. And the reports released this week confirm that trend. The National Federation of Independent Businesses reported that its Small Business Confidence Index fell to 90.8 in June, which the NFIB says is “solidly in recession territory”. On Friday, the University of Michigan’s closely watched Consumer Sentiment Index was released and plunged from 71.5 in June to 63.8 this month, its lowest level in more than two years.

Since consumer spending accounts for 80% of the economy, that continuing decline in consumer confidence alone is a scary trend, and it will not be helped by Washington carrying the country to the brink of the first ever downgrade of its credit rating.

I’ve been predicting a significant stock market correction this summer, not a bear market, but a decline of 18% or so on the S&P 500 that will force the Fed to come in with some type of QE3 stimulus in the fall, which in turn will create the typical positive market in the market’s favorable season next winter.

But I assumed a timely agreement on raising the debt ceiling, and have not factored in the unknown additional negative if the dangerous foolishness in Washington continues to the brink or beyond.

Let’s hope some sense of the reality comes into the situation quickly.

In the interest of full disclosure, I and my subscribers took our previous profits from bonds and our downside positions against the stock market when the recent snap-back rally began, but have repositioned for a resumption of the correction, with initial positions in the iShares 20-year bond etf, symbol TLT, the ProShares Short S&P 500 etf, symbol SH, and the ProShares Short Russell 2000 etf, symbol RWM.

Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free market blog, www.streetsmartpost.com.

These reports reflect our opinions and are based on our best judgment, but no warranty is given or implied as to their accuracy. Past performance does not guarantee future performance.

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