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david rosenberg

David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business

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Is income still king if the United States is downgraded?

The answer is yes.

I realize there is a whole lot of concern as to what happens to bond yields if the rating agencies were to take away the coveted triple-A rating on U.S. government debt. Maybe there would be some brief psychological shock, but then again, who doesn't know that the national balance sheet already looks more like a single-A credit than triple-A? The rating agencies are usually the last ones to figure it out.

The U.S. (not counting contingent liabilities) is within a year of seeing its debt-to-GDP ratio pierce the 100-per-cent threshold (it is estimated to rise to 94 per cent this year from 84 per cent last year), the deficit is well above 10 per cent of GDP (7 per cent on a cyclically adjusted basis) and so is the ratio of debt service payments to revenues. In the past, this trifecta in the past has been the harbinger of credit downgrades. These numbers, by the way, are not at all far off and in some cases worse than in Greece, Spain, Portugal, Ireland, Italy or the U.K.

But what of it? Canada was pushed out of triple-A on Oct. 14, 1992, and did not regain that status until July 29, 2002. Over that time frame, the yield on the benchmark 10-year Government of Canada bond tumbled from 7.84 per cent to 5.29 per cent (a 255-basis-point decline versus a 189-basis-point drop in comparable U.S. yields over that time frame).

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Japan lost its triple-A rating in February, 2001, and over the next three years, the 10-year Japanese government bond yield still ended up declining almost 100 basis points to the lows two years later and the yield is still lower today than it was at the time of the downgrade. It just goes to show that not even the rating agencies or the fiscal largesse is a match for sustained below-trend economic growth in a post-credit-bubble-collapse economy and all of the lingering deflation pressure that comes with it.

You heard right. Deflation.

If this were a normal cycle, the economy would have already responded to the mountain of government reflationary policies that have been in place for nearly two years. For example, if this were a normal cycle, then: Employment would already be at a new high, not 8.4 million shy of the old peak.

The level of real GDP would already be at a new cycle high, not almost 2 per cent below the old peak.

Consumer confidence would be closer to 100 than 50.

Bank credit would be expanding at a 14 per cent annual rate, not contracting by that pace.

If this were a normal cycle, then the U.S. federal funds rate would not be near zero and one in six Americans would not be either unemployed or underemployed.

If this were a normal cycle, then mortgage applications for new home purchases would not be down 13.9 per cent, year over year, on top of the already depressing 29.4-per-cent detonation of a year ago.

But the perception that this is turning out to be a normal sustainable expansion is strong and pervasive, although the reality is that this is just a brief statistical bounce aided and abetted by unprecedented government bailouts and intervention.

Despite massive attempts at monetary and fiscal reflation, which did produce periodic sugar-high influences on growth, government bond yields did not bottom until 2003 in Japan - over a decade after the initial credit collapse. You can see the same thing happen in the U.S. if you look back to 1941.

This is not the story that a "live-in-the-moment" investor may want to hear today, but even as the market lurches forward, the economic outlook is more uncertain than is commonly perceived and I believe investors are taking on too much risk to be overweight equities at this time.

We believe that the primary trend toward consumer frugality, liquidity preference and deflation has not vanished simply because of the impressive bear market rally in risk assets that has occurred over the past year.

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