Why Investors Should Not Overreact to the Credit Downgrade

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 |  Includes: SPY
by: Kevin Mahn

After markets closed for the week, credit rating agency Standard & Poor’s (S&P) announced on Friday, August 5, 2011, that it had cut the sovereign debt rating of the United States of America to AA+ from AAA. The ratings cut was the first downgrade of the U.S. AAA credit rating by S&P since S&P initially granted the AAA rating to the U.S. in 1941.

According to the press release from S&P that accompanied the downgrade announcement,

The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics. More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

Perhaps more concerning than the downgrade itself, which was largely anticipated by the market although the timing was uncertain and arguably questionable, was the following, concluding statement in the S&P press release;

We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

It is fair and worthwhile to point out that the U.S. is not the first country in recent years to lose its AAA credit rating and the U.S. can have its credit rating raised back to AAA in the future as well in a similar fashion to what has taken place in other countries. In this regard, Jon Ogg pointed out in a 24/7 Wall St. article entitled Remaining Countries with AAA credit ratings,

Keep in mind that Japan lost its AAA rating in the late 1990s. It was further downgraded earlier this year. It was as recently as 2009 that S&P cut Ireland’s AAA rating. Italy and Spain were both AAA rated in the 1990s, but Spain was actually raised back to AAA before losing it again in 2009.

According to S&P, sovereign debt ratings above BBB- are deemed to be of investment grade quality and the AA rating, in particular, is associated with a “very strong capacity to meet financial commitments” while a AAA rating is associated with an “extremely strong capacity to meet financial commitments” and is the highest rating within the S&P scale. With an AA+ credit rating, the U.S. is now in the same company as Belgium and New Zealand according to S&P.

S&P Sovereign Credit Rating Summary

As of August 8, 2011 (the list below is not intended to be a complete list but rather a selected group of representative countries):

AAA Countries

Germany

England

Canada

Australia

France

Norway

Switzerland

Hong Kong

Denmark

Sweden

Netherlands

AA+ Countries

United States

Belgium

New Zealand

AA Countries

Spain

Slovenia

AA- Countries

Japan

China

A+ Countries

Italy

BBB+ Countries

Ireland

BBB Countries

Russian Federation

BBB- Countries

India

Brazil

Portugal

CC Countries

Hellenic Republic (Greece)

The other two rating agencies do not necessarily agree with S&P’s credit assessment of the U.S. at this time as both Fitch and Moody’s have maintained the U.S.’s vaunted AAA rating though Fitch has indicated that they intend to review the U.S. rating later this month.

While many validly fear that the downgrade may impact borrowing costs for our country, the larger potential risk, in my opinion, could be related to the types of assets that certain institutions (Ex. Banks) can hold on their respective balance sheets. Such a downgrade, or future downgrades, could force a large scale liquidation of these holdings due to changes in the underlying credit quality.

With this said, no such panic selling of U.S. Treasuries has occurred as I write this post. In fact, yields on 10-year U.S. Treasuries have fallen significantly as prices have increased due to investors shifting money from European debt to U.S. debt following the ongoing problems with the outstanding debt of the PIIGS (Ex. Portugal, Italy, Ireland, Greece and Spain) countries and the lack of market satisfaction with the recently announced bailout plan for Spain and Italy in particular.

While Treasury Secretary Tim Geithner is challenging the math that went into the recent S&P decision, I am hopeful that all of Washington accepts this heightened call to action from S&P to set aside political party loyalties and focus on real, and lasting, fiscal reform.

In our opinion, at Hennion & Walsh, investors should not necessarily overreact to this particular ratings action and the pullback that we have witnessed in the equity markets thus far in August has more to do with the state of the anemic U.S. economic recovery and the on-going debt crisis in Europe than the rating downgrade from one of the three credit rating agencies.

As a result, investors would be wise to let recent market volatility serve as a reminder to revisit their asset allocation strategies to ensure that they have the depth of asset classes and sectors in their portfolios to provide the diversification necessary to help navigate uncertain, and likely turbulent, markets going forward.