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US debt gets downgraded but is ignored again, until the big gun fires

A while before Standard & Poors rating agency downgraded US government debt last year August, another ratings agency, Egan Jones, had already done so. Egan Jones Rating Company is not an obscure backyard operator, but its opinion does not carry the same weight as that of S&P. So the markets hardly noticed this event, and it was not mentioned widely in financial publications.
Yet it was the prelude to the infamous S&P downgrade which certainly rocked the markets violently. So when I learned Egan Jones rating agency had again downgraded US government debt last week, it caught my attention. Not expecting it to have much impact in a week which probably marked the most volatile trading week this year, I scanned several reports for references to the significance of the Egan Jones downgrade. I found only one. The volatility which accompanied the sharp correction which started last week Friday, was by all indications not the result of the rating agency’s view. All major American indices shuddered throughout the week shedding some 4% in market value, but clawing back about 2.5% by Thursday. The VIX again rose to almost record highs reflecting the pervasive doubt and uncertainty as traders took out insurance against market collapse.
In my search for reputable references to the Egan Jones ratings I came across a typical speculators report that deals with crude oil only. And this is where I got the fright of my life. These traders argued a rather technical point why they believe the Brent price of crude will be at US$200 per barrel by the end of this year. That is a shocking projection.
When the markets collapsed in 2008, the so-called sub-prime crisis in the US housing market is always cited as the cause. But the price of crude oil which topped US$145 per barrel shortly before the slide started, is widely regarded as the trigger event. So when a group of specialist traders make out a case for crude to trade up to US$200 per barrel, it makes me very cautious and very scared. Trepidation is the word that comes to mind to describe my disposition especially since it is patently obvious that fundamentals have not improved, instead many have deteriorated. The question that then presents itself is: How much more can the market carry before the wider economy in general, and the financial services sector in particular, grind to a halt again. Or perhaps, this time completely implodes.
When I wrote about forex movement two weeks ago and the impact it has on the value of the local currency, little did I realise what a beating the Rand and the Namibia Dollar would endure. The forex  volatility gained momentum last week resulting in the Rand weakening to above R8.01 to the dollar, coming back to a tad below R8.00 later in the week as the US dollar weakened. Again a very volatile and unpredictable stint for the local currency. When fuel prices again went up this week for the fourth time this year, it signalled the potential for inflation far higher than the current consensus view.
Looking at the most recent local financial statistics one notices improvement in several key areas notably credit extension to the private sector, and the value of new mortgage loans. There are tentative signs of an economic recovery all round. Even the so-called lagging indicators are now showing improvement. For the first time in roughly three years, growth in credit extension to private households, for three months in a row, managed to stay above 10% per month year on year. That is indeed a good sign probably showing improved disposable income, better consumer confidence and an increase in consumer demand. But it also reflects underlying inflationary pressure and I doubt that the repo rate can stay where it is – 5.5% in South Africa and 6% in Namibia.
One of our headline articles dwell on the fact that real interest rate has been negative for the first quarter. This has a significant impact on any investment where fixed income is a consideration immaterial whether that investment belongs to a private individual, a company, or a fund manager.
And with the international economic backdrop again displaying ultra-high volatility, I do not think the next round of inflation statistics will be able to argue the point that headline inflation is subdued.
If crude prices indeed start heading for US$200, it becomes academic to distinguish between headline inflation and core inflation. Disposable incomes will be eroded and to salvage the situation, a rate increase becomes inevitable. That erodes incomes further still, setting in motion a rather predictable cycle for slower growth.
Against this background of uncertainty it starts feeling to me we are back at the beginning of 2010 when any forecast looking deeper into the future than a day or two, essentially became meaningless.
I do not expect a calamitous market implosion (although this is not ruled out) but a prolonged period of volatile and rising inflation will be just as damaging as a short but fierce reversal in market sentiment.

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