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Market Commentary | U.S. Credit Downgrade

August 2011
Greetings!

We know these are unsettling times. You may be wondering how to cut through what's media hype, Washington rhetoric and Wall St. gyrations to figure out what's really happening in the financial markets.

We offer your the following insight. We hope it helps you understand a bit more.
Over the weekend, the United States received a downgrade on their debt. Downgrades are not a good thing.  Ultimately, the market will determine the value of U.S. debt, not the rating agencies.  The rise in Treasuries (decline in yield) after the downgrade is a clear indicator that when there's a flight to safety, U.S. Treasuries are still king.

SO WHY HAVE GLOBAL EQUITY MARKETS DECLINED SHARPLY IN RECENT DAYS?
Volatility yes, but this is not a repeat of 2008.  From July 22 through August 5, the S&P 500 Index is experiencing a greater than 15% decline.  International markets have experienced even deeper declines. There are serious issues facing global markets, including the slow pace of economic growth and sovereign-debt risks.  Overall, the markets are focused on the deteriorating growth outlook for the U.S. and the globe, and the aforementioned stress emanating in Europe, especially Italy (the 3rd largest debtor nation). The economic recovery in the U.S. is fragile, but this is not new information. Economists have been revising their growth estimates lower in recent weeks on news that the first half of the year was weaker than expected and on concerns regarding global growth.  

WHAT HAPPENED TO THE CREDIT RATING OF THE UNITED STATES?
Standard & Poor's (S&P) lowered its long-term debt rating by one notch, from AAA to AA+.  S&P also left the sovereign debt rating on negative outlook, indicating that another notch downgrade could come within two years.

WAS THE DOWNGRADE A SURPRISE?
No. It was well telegraphed ahead of time. S&P had revised its outlook on the U.S. to negative from stable back in April 2011. In July, it placed the rating on CreditWatch negative, indicating a near-term rating change was possible.
 
WHAT DID MOODY'S AND FITCH DO WITH THEIR RATINGS?
Nothing yet.  Both affirmed their respective top-notch ratings on August 2, after the government agreed to a deal to raise the debt ceiling through 2013 and committed itself to about $2.4 trillion in deficit reduction. Both Moody's and Fitch did, however, warn that the U.S. rating is under review and expressed concerns about the trajectory of the federal debt.

COULD OTHER ISSUERS BE DOWNGRADED?
Yes.  The U.S. Treasury is not the only issuer affected by the rating changes. S&P lowered the ratings from AAA to AA+ on selected issuers with close links to the federal government. This included the Federal Home Loan Bank System, Fannie Mae, Freddie Mac and the Farm Credit System. The ratings were also lowered on other FDIC-guaranteed debt issues.

HOW SHOULD INVESTORS THINK ABOUT THE DOWNGRADE?
The downgrade reflects one institution's opinion of the default risk associated with the U.S. The difference between a triple-A or double-A rated credit in terms of default is almost unnoticeable.  This downgrade confirms what investors already know: the U.S. needs a credible long-term fiscal plan.  One potential positive of the downgrade is that it may serve as a wake-up call to politicians to start making the tough decisions.

HOW WILL THIS AFFECT THE MARKETS?
A one-notch downgrade by one institution is not expected to cause significant forced selling on U.S. debt securities. Again, Treasuries rose after the downgrade.  Will foreign investors, who own tons of U.S. Treasuries, suddenly sell off? Doubtful. The U.S. is not the only nation struggling with a debt burden. The U.S. Treasury market is the largest, deepest, most liquid bond market in the world.  No other nation even comes close. Investors may talk about diversifying their holdings away from the U.S., but it is tough to execute. Alone, a lower rating could imply higher rates, but it is impossible to unscramble that from all the factors that drive yields. Even while the rating agencies in the last few months were warning of potential downgrades and revising their outlooks lower, Treasury values were moving up, not down.

WHAT'S THE BEACON IN THIS STORM?
A number of positive forces exist in both the economy and the markets, and there is no reason why we should rule out the possibility of a rebound in the coming months.
  1. First, the near-term default risk in the United States was removed with the debt ceiling agreement.
  2. The market anticipated S&P's downgrade.  It was telegraphed by previous S&P comments.
  3. Corporate earnings have been very strong and seem likely to reach an all-time record this year.
  4. After surviving near-death experiences just three years ago, corporate balance sheets are very healthy, while cash on hand is in record territory.
  5. Compared with 2008, the U.S. financial system today is in much stronger shape. Overall leverage, liquidity, and the quality of loans are markedly different from three years ago.
  6. The labor market looks to be continuing its pace of slow improvement, and the fall in oil prices is likely to help household budgets.
  7. While only a start, the recent debt-ceiling agreement shows that when the stakes are high enough, it is possible for U.S. political parties to find compromises that are acceptable to both sides.
We believe the downgrade is a very public recognition of the challenges the U.S. faces. It reinforces concerns most investors have about the economic outlook.  It may cause additional volatility in the near term but is unlikely to lead to more lasting damage to markets.

Special thanks to our sources: Morningstar, Blackrock, Loomis Sayles, and Putnam Investments. 
If you need assistance navigating the often confusing world of personal finance, please let us know. We work with small business owners and individuals to provide sound, visionary stewardship of their assets.

For our clients, please advise us promptly if there are ever any changes in your financial situation or investment objectives.

 

Feel free to give us a call if you want to discuss anything further.

 

Cheers, 

Paula SignatureMike & Jenn married
Paula and Bill Harris, CFP

WH Cornerstone Investments