Some Delayed Musings on the U.S. Credit Downgrade

Less than two weeks ago, S&P downgraded the debt of the United States from AAA to AA+.

This is the scenario that politicians tried to warn us about and thought they would avoid by passing a debt compromise days earlier.  Obviously, their actions were not enough to satisfy the folks at S&P's sovereign rating desk.

So what has the fallout been?  So far nothing. 

Stocks put on a wild show.  Last Monday was the sixth worst point move in the history of the Dow.  Each day proved to be about just as wild as the last, and by Friday's close we had seen one of the most volatile weeks in market history.  Since no one likes dealing with the stress of daily volatility, let's pretend we took last week off.  We would have returned to find a market that was off about 1.8% from where we left it.  If we waited for Monday's close, markets would actually be up from their pre-downgrade close.

Of course, the downgrade was in regards to our national debt, so it is plausible that stocks may be resilient, but Treasuries would definitely feel the weight of S&P's move.  Instead Treasuries rallied!  Yields fell across all maturities (even before the Federal Reserve released their statement, more on that in a moment).  The media chorus called it a flight to safety, as money flew out of stocks.  Yet here we are 1 week later, stocks have recovered, yet interest rates remain low.  Stocks reversed course, but Treasuries did not.

There are two lessons we believe can be gleaned from this scenario:

First, we believe the S&P downgrade is largely meaningless in terms of U.S. debt.  S&P has largely admitted that the downgrade has little to do with our actual creditworthiness, and more to do with political discord.  Additionally, the value of credit ratings lies in their ability to summarize credit information for debt securities.  In a complicated world of illiquid securities and complex balance sheets, we need firms like S&P to sort out the quality from the junk.  But there is no more liquid, more scrutinized debt than that of the United States.  In this case, I believe the market is a much better judge of quality than any ratings agency, and this past week the market reaffirmed our AAA rating.

Second, perhaps the more important lesson is that the Federal Reserve, through their persistent low interest rate policy, is going to control short term interest rates, now maintaining that they will remain low for the next two years.  We have long maintained that the Fed's accommodative policy will be the strongest impetus for appreciating equity values, and nothing has happened to alter that opinion.

We believe the turbulence in the wake of the S&P downgrade was simply the result of a warranted correction for a market that had gotten ahead of itself.  The effects should be short lived, and we predict stocks will finish the year safely in the green.

One more historical note: The last major economy to lose it's top debt rating was Japan.  The downgrade did not cause a collapse in their debt.  Instead it proved to be an excellent buying opportunity.  One example is not a very significant data set, but it is a clear indication that there is no guarantee the debt downgrade will be disasterous.

*No information in this commentary is meant to be taken as investment advice.  Please contact your financial advisor before making any investment related decisions to be sure they are suitable to your needs, goals and risk tolerance.

Comments

[jennalee]

Yes, Stock market is running like a wild bull these days, Every next day is worst then the day before. I think lawmakers have to do something or USA would be out of business.