U.S. Debt Downgrade
By Jim Baird, Chief Investment Strategist, Plante Moran Financial Advisors
Executive Summary
- Late Friday evening, Standard & Poors (S&P) announced that it had lowered its long-term sovereign credit rating on debt issued by the United States of America from AAA to AA+.
- The fact that Treasury debt was downgraded was symbolically noteworthy, but doesn’t meaningfully change the place currently held by the Dollar or Treasuries in the global pecking order overnight.
- The structural deficits and cumulative debt of the Federal government is a significant problem that must be addressed over time, but the United States is arguably in a much better position than many other developed economies.
- While it is likely that the market’s short-term reaction to this development will be negative, we believe that intermediate to long-term returns will be much more influenced by economic growth, consumer behavior, and long term policy decisions.
- As always, investors should have sufficient liquidity to meet their needs and position themselves to be able to remain committed to their long-term strategy as embodied in their investment policy statement.
Late Friday evening, Standard & Poors (S&P) announced that it had lowered its long-term sovereign credit rating on debt issued by the United States of America from AAA to AA+, a historical first for the United States. In their accompanying comments, S&P specifically noted that they believed the deal recently reached in Washington to raise the debt ceiling “falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.” They also raised doubts related to the “effectiveness, stability, and predictability” of American policymaking and institutions, particularly in an increasingly challenging fiscal environment.
S&P’s decision to downgrade comes after an extended period of heightened attention to the potential for such an event to occur. After sounding warnings in recent months, both Moody’s and Fitch (the other major domestic ratings agencies) recently reaffirmed their highest ratings on U.S. Treasury debt, albeit with a negative outlook. Clearly, the decision-makers at S&P have a different view, but they are not the lone arbiter on these matters. Perhaps more importantly, market participants – not ratings agencies – determine the relative status and pricing of Treasuries in the market. Assigning a value to bonds and currencies is ultimately a relative value decision. The fact that Treasury debt was downgraded was symbolically noteworthy, but was still only an incremental change. It doesn’t meaningfully change the place currently held by the Dollar or Treasuries in the global pecking order overnight.
It’s also worth noting that the Federal Reserve moved swiftly on Friday evening to clarify that this downgrade would not alter the risk weights used by financial institutions for Treasuries or other securities issued or guaranteed by the U.S. government and related entities. This was a critical step to reassuring the financial sector that the regulatory view of the strength of bank capital would not be negatively impacted by the downgrade.
We’ve seen a number of analogies used to describe this “relative value” relationship, but we like the description of U.S. Treasuries and the Dollar as being the best house in a bad neighborhood. As we’ve discussed before, the structural deficits and cumulative debt of the Federal government is a significant problem that must be addressed over time. But the United States is far from alone among the developed countries of the world in that regard and is arguably in a much better position than many of its peers, including Japan and the Eurozone. As such, it is unlikely to be displaced any time soon as that de facto reserve currency and perceived safe haven, as its combination of global presence and relative stability remains unmatched.
Even if S&P is ultimately joined by Moody’s and Fitch in downgrading Treasury debt, such a move need not be viewed as permanent or irreversible. We have certainly made the case that the structural deficits that have plagued the federal government and even accelerated in recent years are not sustainable and must be addressed. We have not been alone; it is not a controversial stance and appears to even be shared by most policymakers in Washington (albeit subject to fierce disagreement about how to correct it). It is also at the heart of S&P’s argument. Whether this decision was justifiable, premature, or off base at present is ultimately not material; the die has been cast. We view it as a hard shot across Washington’s bow – a direct warning that policymakers need to make difficult decisions to meaningfully alter the trajectory of deficit spending.
In a sense, we are in uncharted territory. As it relates to investing while in uncharted territory, we believe the key is in rationally – rather than emotionally – surveying the changing landscape, evaluating the various factors at work, assessing potential outcomes, and advising our clients accordingly. While it is likely that the market’s short-term reaction to this development will be negative, we believe that intermediate to long-term returns will be much more influenced by economic growth, consumer behavior, and long term policy decisions. As is always the case with the many events and issues that shape the direction of the capital markets, news is assimilated, assets are re-priced, and investors turn their attention to “what’s next” on the horizon.
While we cannot foresee the specifics of what the markets hold in the next few days, one would expect that Treasury rates would rise to some degree, the dollar would fall, and risk assets including stocks and credit oriented bonds would decrease in value. It’s likely to be a volatile path, however, as illustrated by the fluctuations in the Treasury yield curve since the downgrade was announced Friday evening. As we write this, Treasury yields are actually lower this morning than they were at the market close Friday afternoon, while the Dollar is mixed against major currencies. While yields could certainly move higher in the days ahead and the Dollar could slip, it appears that – for now – concerns about the global economy may be trumping concerns about the downgrade.
The longer term impact of the downgrade is likely to be driven by how consumers and policymakers react to it. If policy makers do not take appropriate policy actions in response, and consumers decide to crawl back into their shell for a period of time, the potential for the economy to fall back into recession is heightened considerably. As such, the rapidly evolving economic outlook, potential further intervention by other central banks, and the response of policy makers to the widening crisis in the Eurozone are three easily identifiable factors that will likely have a much greater influence on the markets in the weeks and months ahead.
As we noted in our comments sent Friday afternoon, investment time horizon is critical. While this downgrade came to pass mere hours after those comments were sent, it does not fundamentally change our view of the market. This downgrade, as well as the future direction of U.S. fiscal policy, remains a source of uncertainty for market participants. The first is likely to contribute to further market volatility in the near-term as that news is absorbed. The latter is much more important to the long-term trajectory of our economy, consumer and business sector confidence, and capital market returns.
As always, investors should have sufficient liquidity to meet their needs and position themselves to be able to remain committed to their long-term strategy as embodied in their investment policy statement. “Sufficient liquidity” is not a “one size fits all” decision, however, as individual financial goals, liquidity needs, and tolerance for risk are different for every individual. Knowing what those needs are and positioning oneself accordingly, without emotionally overreacting to market events, are critical.
We will continue to closely monitor economic data trends to refine our expectations for the direction and trajectory of the economy as well as developments in the capital markets.
Disclosure: Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors provides this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors or strategies mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.