Sam Stovall: Debt Downgrade Could Lead to Recession

by: Harlan Levy

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Sam Stovall is chief investment strategist at Standard & Poor’s Equity Research as well as the author of The Seven Rules of Wall Street and the column Stovall's Sector Watch, a page on

Harlan Levy: Would a rating downgrade on U.S. Treasuries lead to a return to recession?

Sam Stovall: Yes. I think it would. On Friday we got the preliminary estimate on Gross Domestic Product growth which was a 1.3 percent advance, compared to a Wall Street estimate of 1.6 percent and well below S&P Economics’ 4 percent growth estimate made in March.

Obviously, this new number indicates how fragile the U.S. economy is and how susceptible it is to macro-events such as the disaster in Japan, extreme weather in the U.S., and a spike in oil prices as a result of the Arab spring.

Add to that the possibility of a U.S. debt downgrade, and its likely effect on yields and interest rates, and we believe the U.S. economy could slip back into recession.

H.L.: What are the odds?

S.S.: Even with our 11th hour debt-ceiling miracle, if the Congressional Budget Office projected that the U.S. debt-to-GDP ratio will still exceed 100 percent by 2014, the U.S.’s credit rating may still be in jeopardy.

H.L.: Can our financial problems be solved with substantial cuts in spending, no new tax revenues, and continuation of tax breaks for the wealthy and corporations?

S.S.: Estimates out of Washington are about as reliable as profits statements out of Hollywood. I believe everything should be taken with a very big grain of salt. As our revenue and expenditure policy is today, we could not reduce the debt by merely cutting discretionary spending, which is basically all expenditures except for entitlements – Medicare, Medicaid, and Social Security. To reduce the debt based on expenditure cuts alone, we would have to dig deeply into entitlements as well.

Yet the majority of American would likely not want to reduce our debt by slashing expenditures alone. Tax increases or loophole reduction and elimination would also need to be part of the equation. The proposal issued by the Gang of Six in Congress – three Democrats and three Republicans – outlined dramatic changes to the U.S. tax program, which, based on the detail that was released, seemed to address a variety of these issues and forced a majority of Americans to share the burden. I believe such a program of expenditure reduction and revenue increases will be needed before it will be ultimately approved by Congress.

H.L.: Isn’t the problem the economy faces right now Republican extremism?

S.S.: I believe that the debt ceiling impasse was more acrimonious now than in the prior 53 times that we raised the debt ceiling since Richard Nixon was in office due to the extreme weakness of the U.S. economy, the duration of a jobless recovery, and the amount of stimulus that has been ineffectively pumped into the economy by both political parties, which has resulted in a level of debt that is exceeded only by what we spent in all of World War II.

As a result I believe there are extremists on both sides of the political fence who are adhering to their moral beliefs and making it more challenging to construct a centrist compromise.

H.L.: What do you see ahead for both the U.S. and global economies in light of the fact that because of decades of gerrymandering we may have a polarized Congress possibly for the next 10 years, unable to deal with major issues or crises and unable to pass major legislation?

S.S.: We entered into a secular bear market in January of 2000. It may take us until 2020 before we finally begin a new secular bull market. A combination of extreme levels of debt combined with the inability of political leaders to come to an agreement on how to effectively address this debt may in the long run be the reason we remain in a secular bear market for 10 years and possibly more.

H.L.: Stepping aside from politics, what do the latest data on industrial production, job numbers, jobless claims, and consumer confidence indicate for the economy and in the long run stocks?

S.S.: I think the recent data confirm that we remain in a half-speed recovery. Since World War II the typical Real GDP growth was 6.3 percent in the first year. Yet we only saw 3.0 percent. In the second year the average gain was 4.1 percent. This time we experienced growth closer to 2.5 percent. And in year three, which we entered in the third quarter of this year, we typically saw a 4.3 percent advance but will likely see growth of only around 2.5 percent.

We might find that we are simply going through an economic soft patch that will begin to pick up speed as the year progresses, but I still believe that this economy is in such a fragile state that additional external shocks, such as a U.S. debt rating downgrade or even another global natural disaster could easily throw us into another recession.

In turn, I believe that the U.S. stock market could easily slip into another bear market. If one believes that the 2000s are a repeat of the 1930s, remember that we experienced four bear markets from 1929 to 1942, with three of them being declines of in excess of 40 percent.

S&P currently believes, however, that we will not be falling into recession and that the S&P 500 will be trading around 1,400 by this time next year. Obviously this meager projected advance labels us as single-digit bulls.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.