The world's safest asset may no longer be devoid of risk according to Standard and Poor's (S&P). The international credit ratings agency downgraded the United States AAA rating one notch lower to AA+, and assigned a negative outlook to the sovereign's long-term credit rating on August 5. The unprecedented downgrade of the world's largest economy came days after US policymakers raised the country's debt ceiling by US$2.1 trillion, following weeks of political indecisiveness. It should be noted, S&P's decision to downgrade the US was at odds with the other international rating agencies, Moody's Investor Services and Fitch Ratings. The US AAA credit standing was affirmed on August 2 by Moody's and Fitch after the debt ceiling issue was resolved.
S&P's rating rationale
S&P's first action came in April when it assigned a negative outlook to the US, citing concerns over US policymakers' indecision in formulating and implementing a course of action to address the country's debt sustainability. At that time, the agency assigned a one-in-three probability of a rating downgrade.
In its rationale for the rating downgrade in August, S&P explained that their action stemmed from United States' high debt levels and lack of sufficient measures to stabilise the debt position.
The rating agency also indicated that it expects US net general government debt levels to increase from approximately 74 per cent of gross domestic product (GDP) at the end of 2011 to 78 per cent of GDP in 2021, and the Budget Control Act passed by policymakers, would be insufficient to stabilise the government's debt burden. S&P asserted that another reason for the downgrade was the lack of political consensus required to ensure a comprehensive fiscal consolidation programme. The political controversy which engulfed the US, regarding the right mix of spending and taxation measures necessary to curb the country's deficit, was used by S&P to highlight the rift between the political parties.
Market response
The increased risk aversion which gripped financial markets, stemmed from the oscillating European debt saga and fears of recession due to the weak economic performance of the US. The decline in investor confidence resulted in a slump of international equity markets and a flight to "safe-haven" assets such as US Treasuries and gold. The flight to safety caused gold prices to soar to historic highs over the past few weeks (Figure 1). Theoretically, the downgrade of the US credit rating should increase the country's cost of borrowing, reflected by higher yields on US Treasuries. However, subsequent to the downgrade, the inverse occurred and investors flocked to the safety of US Treasuries, causing price increases and a decline in yields as illustrated in Figure 2.
The rally of US Treasuries following the downgrade highlights the role of the US Treasuries as safe-haven assets. Major holders of US Treasuries, such as China, Japan, United Kingdom and Russia, indicated they still perceived US Treasuries as being risk-free and do not view the downgrade as being significant. However, the recent rally could also be partially explained by the lack of suitable alternatives "safe-haven" assets which possess the depth and liquidity of US Treasuries market.
The effects of the US' credit event were more pronounced in equity markets. In the first day subsequent to the downgrade, panic selling resulted in the S&P 500 Index declining by 6.66 per cent and the MSCI World Equity Index falling by over five per cent. Year-to-date, the major equity indices globally were in negative territory. The S&P 500 Index decline by 6.15 per cent, while England's FTSE 100 and Japan's Nikkei fell by 9.83 per cent and 12.37 per cent, respectively, year-to-date.
2008 déja vu?
The turbulence in financial markets, the magnitude of losses in equities and marked increase in risk aversion subsequent to the downgrade reminded investors of the 2008 financial crisis. Panic selling resulted in S&P 500 Index experiencing the worst day since 2008, with all the stocks in the index being in negative territory at the end of the first trading day following the downgrade. While investors may be tempted to draw a parallel between the 2008 financial crisis and the present sell off in the equity markets, there are marked differences between these two scenarios. The balance sheets of most corporations today are significantly stronger than 2008, owing to higher levels of profitability, large cash reserves and limited debt.
The recent slump in the equity market was based on the lack of investor confidence in the economy rather than fundamental analysis. This is evidenced by the strong corporate performance in the second quarter of 2011, with more than 76 per cent of companies in the S&P 500 exceeding analysts' expectations. Unlike in 2008, financial systems today are better prepared to deal with a crisis. High capital ratios of banks enable them to be better equipped to deal with any significant loan losses unlike in 2008. Additionally, the 2008 credit crunch which was characterised by banks' unwillingness to extend loans to corporations and declines in the availability of funding is unlikely to be repeated presently.
Current interest rates in developed countries are at historic low levels and central banks are committed to provide liquidity support facilities if needed during market turbulence.
Presently, energy prices are significantly lower than in 2008, which may encourage economy activity. Lower commodity prices should reduce inflationary pressures in emerging markets and benefit consumers. Corporations will also gain from lower commodity prices, owing to reduced input costs, which should result in higher profit margins.
Where should the investor be positioned?
In turbulent times such as these, investors are reminded of the benefits of holding a diversified portfolio of assets. Fixed income markets tend to be less volatile than equity markets. In addition to their stability, fixed income instruments possess the distinct advantage of a fixed and steady rate of return. However, investors should take care when selecting fixed income assets and focus on high quality, investment grade bonds. Investors with higher levels of risk appetite may consider corporate bonds, which have greater potential to outperform their sovereign counterparts. Additionally, investors may look to companies with solid financial performance and high credit standings. Emerging markets are generally preferred owing to their strong economic performance, attractive rate of returns and relative detachment from the sovereign debt crisis.
However, investors with higher levels of risk aversion should adopt a wait-and-see approach and may consider keeping their assets in less risky investments, such as money market accounts or maintain cash positions. The reaction of the financial markets to the downgrade of the US credit rating was based on the flight to safety as risk aversion increased. Most holders of US debt view the downgrade as insignificant and US Treasuries maintain their coveted position as a safe-haven asset in the short term.
However, there is still a fair amount of uncertainty surrounding the economic outlook in the US and the world. Thus, investors are encouraged to conduct proper due diligence and contact a financial adviser before making investment decisions.
Bourse Securities Ltd
askus@boursefinancial.com or
624-0000/628-6204
