Making Sense of the Ratings Downgrade and the Market Response

August 10, 2011

Last Friday, S&P announced it downgraded U.S. long-term government debt from AAA to AA+ with a negative outlook.  While we are not surprised by this news, we did not expect it to arrive so soon.  Furthermore, on Monday, entities with ties to the U.S. government backstop were also downgraded, including Fannie Mae and Freddie Mac.  S&P explained that the entities that were downgraded have debt that is exposed to economic volatility and would be affected by a further downgrade of long-term U.S. debt.  The creditworthiness of these entities hinges on the U.S. government’s ability to pay its own creditors.  Fannie and Freddie account for the majority of new mortgage loans, and as a result of their downgrade mortgage rates may increase. 

S&P explained that it downgraded U.S. debt for the first time in history because the credit rating agency lacks confidence that political leaders in the U.S. will make the necessary choices to avert a long-term fiscal crisis.  S&P was expecting a deficit reduction of $4 trillion dollars or more, fundamental tax and entitlement reform, and a substantive plan.  In their opinion, the recently negotiated budget agreement falls short of what is needed to stabilize the rising U.S. debt, and that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers. 

Regardless of the downgrade, few alternatives exist for investing in AAA rated sovereign debt, as illustrated by the chart below.  With the U.S. representing 55% of that market, even at AA+, our country will continue to provide the liquidity and supply needed for sovereign debt investments. 

AA represents high credit quality. Both China and Japan, the No.2 and 3 economies in the world, hold a credit rating of AA.  It is also worth noting that Japan has never missed a debt payment, and that China is the U.S.’s largest foreign creditor.  Other AA borrowers include Belgium, Israel, and Taiwan.  In addition, Australia, Canada, Denmark, Finland, and Sweden have, at some point in the past, lost their top-notch ratings before working their way back to AAA.

Foreign governments have had mixed reactions to the recent events. While China has criticized the U.S. in the wake of the ratings downgrade, the Chinese rating agency continues to give the U.S. its highest grade.  Japan, the U.S.’s second largest creditor, voiced its support, with a senior Japanese government official saying the trust held in U.S. Treasury notes “and their attractiveness as an investment will not change because of this action.”

However, global equity markets have responded negatively to the news. Most Asian and European markets were down anywhere from 2-5% on Monday; the U.S. markets followed suit, with a 6.6% decline on the S&P 500.  Year to date the S&P 500 is down over 11%, and more than 16% since quarter end.  Despite the implied risk in treasuries, yields continue to fall and the dollar is strengthening, demonstrating that the U.S. is still considered a safe harbor during volatile economic times.

At Miller/Russell, we believe that despite the downgrade and subsequent market performance, investment fundamentals remain largely unchanged. The market is reflecting an emotional response to the ratings downgrade, revisions to U.S. economic data, and the European debt issues, but not fundamental changes to corporate earnings growth. We hope, as do many others, that the end result of the downgrade is a sense of urgency within Congress to address S&P\\\'s long-term debt concerns. Any solution will require a disciplined plan to both cut entitlement spending and reform the tax code.

The downgrade could ultimately prove fruitful, if Canada\\\'s experience is any guide. Faced with serious economic troubles in 1994, Canada took steps to balance its budget and create conditions conducive to job growth. By 1997, Canada had moved its budget deficit to a surplus and regained its AAA rating.

If Congress takes the necessary steps to address the issues, the inevitable result will be slower growth in the U.S., which the stock market could be anticipating. However, because the majority of earnings for large domestic companies are generated outside the U.S., we believe that corporate profits will move in a positive direction, and that a global investment strategy will prove effective. Furthermore, future actions or events may offset increased taxes and spending cuts to support GDP growth in the future.

Even if the market reaction reflects anticipated slower growth domestically, we believe the last week has left relative valuations at attractive levels. In light of the volatility, equities are still trading at a 25% discount to long-term historical averages. Despite such a rapid decline, we see no need to sell equities. Our continued development of the fixed income and multi-strategy portion of client portfolios is proving to be valuable, as these areas of the portfolio have provided a buffer to stock market volatility. A balanced approach remains the best strategy in uncertain markets, and investors that remain fully invested will eventually be rewarded for bearing the risk in equities today.

As noted in our quarterly newsletter, our Investment Policy Committee focuses a great deal on managing risk.  We want to ensure our clients that we continue to monitor market and economic activity; however, we believe we are currently well positioned to manage the current volatility, as well as participate in the market recovery.  We are actively reviewing client accounts to maintain consistency with our long-term investment strategy, and expect that once the emotion in the markets subsides, prices will return to fair value.

As always, if you have any questions, please contact us.

Miller/Russell & Associates