The Real Concern Is U.S. Credit Rating Downgrades

Includes: SPY
by: Shane Zhao

The main focus on the market right now is the fiscal cliff; however, my concern is not whether we will climb over or fall off the cliff. My real concern is the deadlock of fiscal cliff will lead the US to another credit rating review, which would ultimately lead to a credit rating downgrade. At this point, it does not matter what the fiscal cliff outcome will be. The US credit rating will likely be downgraded by the credit rating agencies, such as Moody's and Fitch.

Last summer, when the debt ceiling problem lingered, we all knew both parties were playing chicken and a deal would be reached eventually. It was simply because neither party wanted to be blamed for causing a US default. It was pretty much a no-brainer that the debt ceiling would get raised.

The key measure on sovereign credit quality is debt-to-GDP. In the case of the US, it has risen dramatically from 75% to 104% debt-to-GDP. In other words, US GDP totals $15 plus trillion while debt totals more than $16 trillion.

We know rating agencies are on the move, as they just downgraded France, the second largest economy in Europe. Sure, there are massive differences between the US and French economies. The things that matters to rating agencies, such as debt and deficits, are in fact wider in the US than France. S&P has already downgraded the US rating. Moody's has yet to take such action, but it has warned the rating is under constant review and the policy reaction to the fiscal cliff will be critical to its assessment.

The effect of the fiscal cliff is somewhat a lose-lose situation for the US credit rating.

One outcome of the fiscal cliff is that both parties come up to some kind of agreement and extend the deadline for tax increases and government spending cut. Such agreement most likely would include an increase in the debt ceiling limit sooner than later. It will increase the size of US deficit due to an extended period of tax cuts. Both Fitch and Moody's already stated in September that failure to reach a credible deficit-reduction plan probably would lead to a downgrade of the US rating. If the deadline gets extend, it can be considered as a failure of taking the first step to reduce the US deficit. A downgrade may be issued by both agencies.

The other outcome is the US fails to reach a temporary arrangement to prevent the full range of tax increases and spending cuts implied by the fiscal cliff. It will be interpreted by the market as though the general election had not yet resolved the political gridlock in Washington, which sends a negative signal to the public about both parties' willingness to pass any bipartisan agreement. The lack of confidence to the government's ability to reach a creditable plan to stabilize federal debt over the medium term will likely result in a rating downgrade.

As an investor, even with the down trend after the election, I would not jump back to the equity market just yet. I would still park my money on the sidelines and wait for a more clear picture after the end of the year. Since the S&P 500 entered 1,400 points, investors should be careful for a large correction. With the uncertainty haunting the market, not losing money is already winning in some ways. If you already have big part of your portfolio in long positions, I would recommend you enter into a put option in SPDR S&P 500 ETF Trust (NYSEARCA:SPY) to limit the downside. At this point, I am more than happy to know my money is safe than being sorry two months from now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.