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As the debate over the debt ceiling continues in Washington, I, like most market watchers, believe that a deal will be reached and the debt ceiling will be raised.

Rather than whether a deal will be reached or not, the big outstanding questions now are whether credit ratings agencies will downgrade U.S. debt from its AAA rating even if a deal is reached and what the fallout of such ratings downgrades would be.

In terms of what kind of deal I expect, I believe the beginning of a compromise solution between the parties is starting to emerge. Ultimately, I believe that the final deal will raise the debt ceiling and will include a modest headline deficit reduction number (probably somewhere in the $1.5 to $3 trillion range), of which a good portion of the savings will remain unspecified for now. In addition, the deal will likely include some future mechanism, such as a committee, for exploring a more significant deal in the future. The major issues such as revenue and entitlement spending that will determine fiscal solvency over the long term, however, are unlikely to be addressed prior to 2013.

As for the more pressing question of the chances of a downgrade, I believe there is roughly a 50% probability of a downgrade if the final deal contains headline cuts around $2 to $2.5 trillion - roughly the size of the cuts in the Senate plan. If however, the cuts associated with any hike in the debt ceiling come in below that level, I believe the odds of a downgrade go up.

So what would a post-downgrade environment look like? The near-term implications are uncertain as there is no precedent for this type of event. Not only has U.S. debt always been rated AAA with no previous instances of a downgrade, but there has never been an instance in history - at least that I’m aware of - in which the issuer of the reserve currency was also the biggest debtor. In short, we’re in unchartered territory. Still, it’s almost certain that a downgrade of U.S. debt would be highly disruptive to financial markets.

Longer term, the implications of a downgrade are clearly negative. It could lead to higher borrowing costs for the U.S. government, corporations and consumers. Higher borrowing costs would then be a drag on economic growth, corporate profitability and overall U.S. living standards. A downgrade would also add to inflationary pressures by putting the dollar at greater risk of a significant long-term decline.

So what would a downgrade mean for investors? Overall, a downgrade would not change my views. I have been speaking about an environment of higher volatility since April. Given that expectation, in the event of a downgrade, I would continue to favor mega caps and defensive sectors (including healthcare and global telecom, in particular). And as investors wait to see whether a downgrade happens or not, investors can consider these same plays.

I also continue to hold a negative long-term view of U.S. Treasuries. That said, given the anemic state of the economic recovery and the growing risk aversion in market places, Treasuries may not necessarily sell-off in the near-term after a U.S. debt downgrade. My negative view on Treasuries has a longer-horizon and is based on low real yields and a deteriorating fiscal picture, which would be confirmed by a downgrade.

Finally, even if U.S. debt is ultimately not downgraded in the coming weeks, investors need to realize that the U.S. fiscal situation - similar to that of Europe - is an ongoing chronic problem that is unlikely to be fully addressed in the near term. In other words, we are likely to revisit this issue again over the next 12 to 18 months.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.

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Source: The Chances of a U.S. Debt Downgrade