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Weekend Edition

The Best of The S&A Digest
Saturday, March 27, 2010

The bond market has actually begun to price government obligations at higher interest rates than highly rated private companies.
 
For example, two-year notes from Warren Buffett's Berkshire Hathaway are yielding less than Treasuries of a similar maturity – same with debt from Procter & Gamble, Johnson & Johnson, Abbott Labs, Royal Bank of Canada, and Lowe's.
 
We've been predicting this would happen for some time. To keep you informed and hopefully entertained, let us expand on our premise...
 
We believe the debt of nearly every government in the world will soon trade at a significant premium to the best-run private companies.
 
The reason is quite simple: As long as they don't have to pay for it, people will always vote for more government spending. That leads politicians to implement strategies that shield the true costs of government spending from the majority of voters – using debt and steeply progressive taxes. Today, roughly half of all Americans pay zero federal income taxes. As a result, it's not hard to win an election promising more things, like "free" health care.
 
This isn't really a political problem. It's actually an economic problem. There's a structural asymmetry between the people who approve the budgets (through elections) and the people who have to finance the budgets. Eventually, this will lead to a complete fiscal collapse. And it's going to happen a lot sooner than people think because the bondholders aren't stupid. They can see where the trend is heading.
 
And that's why it costs OBAMA! more to borrow money than Warren Buffett.
 
This is happening all over the Western world. Nearly every single major nation – the so-called G7 – will have debt-to-GDP ratios that exceed 100% by 2014. The exceptions are Canada and Germany – at least if Germany decides not to bail out Greece, Spain, Portugal, and Italy.
 
The problem is, once creditors begin to fear more and more paper will simply be printed to pay these debts (and, of course, that's what will happen), interest rates will rise. And they could rise suddenly. That would force governments to spend vastly more money on interest payments than they expect. That's the big problem right now in Greece, for example. I believe the U.S. will be spending close to 25% of its income tax receipts on interest by 2015. That's simply not sustainable.
 
 Sooner or later, something will have to give... whether that's taxpayers abandoning the country or the government vastly expanding the tax base. The same will be true for just about every other major Western country.
 
It won't just be the Greeks rioting in the streets. People here, just like over there, have gotten used to getting something for nothing. And they're going to be very angry when the gravy train comes to an end.
 
While we don't really expect this anomaly – triple-A-rated corporate bonds trading at higher prices (and lower yields) than U.S. Treasuries – to last, it certainly is evidence the marketplace believes government debt is more likely to be downgraded than certain sound companies.
 
Today, there is an even stranger anomaly: 10-year swaps are now "trading through" Treasuries, meaning at a higher price and a lower yield. These swaps have the same creditworthiness of double-A-rated corporate bonds.
 
Thus, the market seems to think that, in the next 10 years, U.S. Treasuries will be more of a credit risk than double-A-rated paper.
 
These currency problems aren't unique to America – not at all. In fact, we think the euro will fall apart first. In January, Steve Sjuggerud told his True Wealth readers to short the European currency, saying it was obviously doomed:
 
If you don't save Greece, if you kick Greece out of the euro instead, then you're faced with more hard choices. Which of the other PIGS do you boot? This would create extraordinary uncertainty. When the possible outcomes are 1) extreme weakness to finance bailouts or 2) extreme uncertainty, where you don't know what countries are in or who's in charge – it's time to bet against the euro. – Steve Sjuggerud, January 2010, True Wealth
 
The euro hit a 10-month low this week on more bad news surrounding the PIGS (Portugal, Italy, Greece, Spain)... Credit ratings agency Fitch cut Portugal's credit rating for the first time, down one notch to AA- with a negative outlook.
 
Portugal's deficit is 9.3% of GDP, more than triple the 3% European Union mandate and much higher than a typical AA- credit risk. Concerns also mounted that the EU must enlist the International Monetary Fund to aid in a Greece bailout.
 
UBS deputy head of global economics, Paul Donovan, put it best... Greece "is going to default at some point. If Europe can't solve a small problem like this, how on earth is it going to solve the larger problem, which is the euro doesn't work?" Steve's trade is up nearly 15%.
 
In his latest issue, Steve tells readers about "quite possibly the best investment [he's] ever seen." This investment has never lost money in a calendar year going back 30 years. It has beaten stocks with much less volatility over the same period. And it has zero correlation with the stock market.
 
Steve has actually worked with a creative financial firm to create this investment. And due to certain guarantees (we can't give away the details here), this investment has no downside risk. It's the ultimate market insurance.
 
As Steve wrote, "When the whole world falls (like in 2008), this still makes money." To sign up for True Wealth and access Steve's latest recommendation, click here.
 
Regards,
 
S&A Investment Research




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