S&P downgrade of US sovereign debt: investment implications

what S&P said

After the stock market close in New York last Friday, Standard and Poors’ Ratings Direct issued a research report in which it downgraded the long-term credit rating of the United States from AAA to AA+, with a negative outlook.

According to S&P, “negative outlook” means that there’s at least one chance in three that it will downgrade the US further within the next two years.

Short-term paper remains unaffected, with a A-1+ rating.

its reasoning

Two main factors:

–the rising public debt, and

–the fact that “elected officials remain wary of tackling the structural issues” in a way that AAA countries are expected to do (which I read as meaning that S&P regards government in Washington as a bunch of wannabe ballplayers wearing big-league uniforms and demanding big-league perks but who can’t hit the ball out of the infield ).

Apparently, the performance of all parties to the debt ceiling debacle was enough to make S&P revise down the opinion it formed in April.

who doesn’t know this already?

I think it would be hard to find any professional fixed income investor who isn’t aware the US has a debt problem.  In fact, over my thirty+ years watching the stock market, conventional wisdom (and actual experience) has always been that the rating agency opinions are lagging indicators of financial health.  To my mind, one of the crazier aspects of the sub-prime mortgage bubble is that professionals actually claimed they relied on the ratings, rather than doing analysis themselves–kind of like depending on last year’s calendar to tell you the day of the week.

As Casey Stengel would have commented, ” You could Google it.”   In round numbers, Washington has $2.5 trillion in annual income but spends $4 trillion.  Outstanding federal debt is already over $14.3 trillion, or about six years’ worth of gross income.  And that doesn’t count $40+ trillion in the present value of retirement and medical care promises Washington has made but hasn’t set aside the money for.

investment implications

short-term

There may be a day or two–if that–of negative reaction in both stocks and bonds to having the S&P shoe finally drop.  Otherwise, in the short term, I think there are no negative consequences.

Two other ratings agencies, Moodys and Fitch, have already reaffirmed their AAA rating of US sovereign debt.  So it’s unlikely that any large investor has a contract that will force it to sell Treasuries.

Besides, where else is there the same combination of liquidity and relative safety that still exists in Treasuries  …Japan?   …Italy?    I don’t think so.

In addition, as I mentioned above, this is scarcely a surprise.

longer-term

This is much harder to handicap.

On the one hand, the downgrade will doubtless cause China to increase its efforts to create a substitute for the dollar as the global reserve currency.  As Xinhua, the Chinese news agency puts it, “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”  In the same article, Xinhua also calls for international supervision of the issuance of dollar obligations, and the establishment of a substitute world reserve currency.

On the other,  Americans’ opinion of Congress is at an all-time (meaning since the Seventies) low, with 82% rating legislators unfavorably.  The New York Times, a Democratic bastion, just ran an op-ed piece arguing the country would be better off with Richard Nixon as president than Barack Obama.

It’s at least possible that the embarrassment of a national credit downgrade after 70 years of AAA will sharpen political debate and influence the next national election–coming in November 2012.  The groundswell appears to me to be already taking form.  If so, the public outcry may well influence, in a favorable way, the recommendations of the congressional committee being established to make budget-balancing recommendations as part of the debt ceiling deal.

Who knows.

I also think this event brings us closer–both in time and value–to a buying opportunity in world markets.  Today will be an interesting day to watch closely.