S & P Downgrade Market Commentary
As markets continue to roil with news of Standard and Poor’s downgrade of the United States sovereign debt from AAA to AA+, Equitas would like to take a moment to offer some insights on the situation as well as the European debt issues and market outlook.
On Friday, the credit rating agency Standard and Poor’s announced that it would lower the US credit- rating for Treasury debt one notch from the top-rated AAA to AA+. The downgrade, which came on the heels of the much publicized debate over the fiscal budget in Washington DC, represents the first time in American history that US sovereign debt fell below the sterling AAA level. In addition, S&P also placed the US on â€œnegativeâ€ outlook, meaning that a further reduction in the Treasury credit rating was possible in the next two years.
According to S&P, the change in rating drops America’s capacity to fulfill its financial commitments from â€œextremely strongâ€ to â€œvery strong.â€ S&P serves as one of three major credit rating firms. The other companies, Moody’s and Fitch, kept the United States at their highest-rated level, although both have warned of potential future downgrade should the status quo remain in Washington.
S&P Credit Ratings of Select Countries
Credit ratings remain important to both borrowers and lenders. If a bond has a lower rated credit, then there is higher possibility that a borrower (the US Treasury) does not repay its lender (Treasury bond holders). In turn, the lenders will require more compensation (interest rates) to mitigate the risk of loaning money. In the case of US Treasuries, a lower credit rating could raise the cost of borrowing not only for the government, but also American companies and consumers. Some estimates put the added interest expense for the US at an additional $110 billion per annum.
In the immediate aftermath of the downgrade, however, we have witnessed the opposite effect: the market has purchased Treasuries, thereby lowering the borrowing cost. The 10-year Treasury yield fell from 2.58% before the announcement on Friday to 2.34% as of the close of business on Monday, August 8. Perhaps more telling, the 10-year dropped to its current level from 3.36% at the beginning of 2011before the credit rating agencies began warning of potential downgrades, compared to many European sovereigns which have witnessed their cost of borrowing rise dramatically.
The yields illustrate several points. First, while the market may factor in credit rating agencies, it is by no means beholden to them. Next, in uncertain economic times, as much of the past few years have been, the world still views US debt as a safe haven investment. Finally, and perhaps most important, it displays that the United States is in no imminent danger of defaulting on any of its future obligations.
While the Treasury market has shrugged off the downgrade in the short-run, the news has reverberated through other markets, and Washington, as well as the American people, should use the downgrade as a wake-up call to curb their enormous spending habits. Deep, fundamental issues remain with the US balance sheet. Over the past decade, the US has enacted tax cuts, engaged in three wars, and dealt with the largest recession since World War II. All have had an enormous impact on both the budget deficit and the national debt. The deal recently passed in Congress on August 2, 2011 made only a small dent in the fiscal issues (See: Equitas’ â€œFederal Budget 101â€).
The greater long-term threat, however, stems from the unfunded liabilities such as Social Security, Medicare, and Medicaid. With the American population growing older and the Baby Boomer generation beginning to retire, nearly all analyst estimates expect the size of the budget deficit to increase substantially. In the near future, expect more political fighting as entitlement reform, along with tax increases and spending cuts, will be forced to be address.
The future impact of the S&P downgrade remains to be seen. At Equitas, we hope that the event will serve an inflection point in economic policy leading to a return of sustainable, long-term American growth and prosperity. As investment advisors, we will continue to closely monitor the situation and search for opportunities in the volatility.
Eurozone Debt Issues
While the US has many long-term structural issues, many solutions exist with political will and sacrifice that can stave-off a long-term crisis. On the other hand, Europe faces a more pressing sovereign debt problem. Numerous countries have already raised taxes and enacted austerity in order to solve fiscal issues.
In order to better understand the current problems facing the Eurozone, a simple analysis of ways of solving debt issues is necessary. In essence, three methods exist for a state to pay off its debts:
- Increase its revenue (raise taxes).
- Decrease expenditures (cut spending through austerity).
- Make the debt outstanding worth less by slowly debasing its currency through inflation.
The last option represents the most politically palatable choice because the effects appear the most subtle to a country’s citizens (provided inflation remains in at reasonable levels). At Equitas, we expect to see a mixture of all three options to solve any US debt issues; though we would expect that currency debasement will continue to play a prominent role.
Europe is different. The Europe Union serves as monetary entity and has no fiscal authority. Therefore, the EU has no power to tax citizens or cut spending, thus eliminating two avenues to reduce debt levels. Fiscal authority falls on the individual nations, which have heterogeneous economies as well as debt levels. Recently, tax hikes and spending cuts have caused social issues from Athens to Madrid.
The final option, a slow debasement of the Euro currency, seems unlikely for several reasons. First, the stronger economies (Germany and France) want to avoid a weaker Euro. In addition, Europe has a bad history of inflation. The German Weimar Republic in the 1930s experienced hyperinflation which leading to the economic hardships that many historians believe aided to rise of Adolf Hitler. Finally, while the US Federal Reserve has dual mandate of an inflation target around 2% and maximum employment, the European Central Bank only one: an inflation level below 2%.
The European countries facing the most pressing debt problems include: Portugal, Ireland, Italy, Greece and Spain (the so-called PIIGS). Over the past decade, the PIIGS have become over-levered by borrowing large amounts debt at artificially low EU interest rates. While Greece represents the audacious offender, all the countries have significant concerns. In addition, many French and Germany banks hold large amounts of sovereign debt from the PIIGS. Should the any of the countries default on their obligations, the European banking sector could face systemic risk.
The European sovereign debt crisis will not be solved overnight. European policy makers must derive a coordinated, comprehensive plan that will address sovereign debt. Ad hoc intervention in the markets will not solve the long-term problems. Investors should expect bailouts of the PIIGS to continue as Europe muddles through.
As investors digest both the S&P downgrade and news from across the Atlantic, expect volatility to continue. The CBOE Volatility Index (VIX) has more than tripled from July 1 to August 8, 2011 to levels not seen in over a year, although volatility is still only half of levels reached in 2008. Markets will remain unpredictable over the near-term as participants digest economic data.
While volatility will remain, trading ranges could also start becoming evident. With the massive selloff over the past few weeks, valuations on the US equity market have become extremely attractive. Rebalancing a portfolio back to equities and commodities could provide for solid returns in the near term.
Although much stronger than in 2008, the US economy remains on fragile terms. While the headline unemployment rate stands at an elevated 9.2%, the more comprehensive U-6 unemployment rate, which includes â€œmarginally attached workers and those working part-time for economic reasons,â€ sits at a staggering 16.1%1. In addition, the housing market has yet to recover from its bubble bursting, and consumer confidence remains weak.
Should the economy continue to struggle, expect more stimulus programs from the government. While the Fed’s QE2 program helped prop up asset prices, most notably equities and commodities, it failed to spur employment and became the target of political anger as many blamed it for the dollar’s continued decline. If the economy falters, the Fed will attempt to generate a new form of stimulus, just not call it â€œQE3.â€
At Equitas we continue to closely monitor the developments in the markets. Our extensive due diligence and rigorous asset allocation process should dampen the expected volatility. We believe that the current market environment may serve a buying opportunity for our clients with a long-term time horizon for investments. For instance, many blue chip companies are flush with cash and offering dividend yields higher than some fixed income markets, an occasion not seen since the 1950s. As always, diversification and low correlation between asset classes will offer opportunities to navigate tumultuous markets and reach your objectives. Long-short equity managers, hedge funds, and managed futures all can capitalize on market volatility and offer opportunities for solid returns during market environments similar to the current one.
As always, do not hesitate to reach out to us with questions or comments.