The Downgrade Does Matter, But Not for the Reasons the Headlines ShoutAugust 2011
Late Friday night Standard & Poor’s announced that it downgraded the long-term debt obligations of the U.S. government and its related entities. Although the possibility of this rating action was well telegraphed, the timing was a surprise to some.
The rating agency was particularly clear. In order for the government to maintain the AAA rating, S&P needed to see a meaningful and credible deficit reduction plan in place that would begin the process of addressing the large structural deficits and the explosive growth in our accumulated debt levels.
The Debt-to-GDP Ratio Hits a Level of Concern
Countries that allow their debt burden to rise to a level that is equal to the level of economic output (GDP) are vulnerable to lose their top tier rating. Clearly Washington’s political rhetoric contributed to S&P’s loss of confidence in policy makers’ ability to slow or reverse the march toward a 100% debt-to-GDP ratio. As such, S&P acted consistently with its method.
A U.S. Default, As Some Loose Talk Has Suggested, Will Not Occur in Our View
- Indeed, Credit Default Swap spreads, a measure of the expectation that an issuer will default, have fallen from a peak on July 28, although last week's turmoil saw a small uptick.
- The dollar made its low on April 29, and has been working higher since, albeit with much volatility.
- The issue at hand today is more political than economic: interest rates are at rock-bottom, and banks and corporations are awash in cash. Indeed, the Bank of New York is now making its large depositors pay for the privilege! Local governments and individuals are already making the tough choices: cutting spending and saving more. Lastly, corporations are reporting strong gains in earnings.
U.S. Treasuries Have Not Lost Their Appeal—Yet
Although the implications of the downgrade should not be minimized, the near term impact on bond markets might be more modest than we are seeing among equities. Most investors have recognized the fiscal implications of the federal government’s counter-cyclical fiscal policy and lack of fiscal discipline. Investor perception appears to be that the creditworthiness or claim-paying ability of the federal government is not in question. Over time, however, unless Congress acts, we are likely to see bond buyers demanding a higher interest rate to hold government issues. Thus far, the federal government has continued to be able to raise large amounts of capital at historically low interest rates. We do not see this changing.
Global bond investors have continued to view the U.S government fixed income markets as the safest, deepest and most liquid in the world—this relative status has not yet been affected by the change in rating. In fact, since the financial crisis broke, world central banks have increased their holdings of U.S. Treasury debt by over two trillion dollars.
The Downgrade Has Implications for Other Issuers
U.S. Treasury debt now has a split long term credit rating of AAA, AA+, AAA by Moody's, S&P and Fitch, respectively. In addition to U.S. Treasury notes, agency debt issued by Fannie Mae and Freddie Mac, federal farm credit, federal home loan bank as well as others will also be downgraded by one notch. The magnitude of this rating shift is fairly broad based, essentially affecting over 75% of the investment grade taxable bond universe. The implications of the rating revision are not limited to the taxable bond market. The downgrade of the government’s rating potentially affects over 7,000 issues within the municipal bond market. Pre-refunded debt, certain housing and health care issues and a number of states that receive significant revenues from federal government transfers and payments are likely being reviewed for possible downgrade.
We Remain Focused on Capital Preservation and Individual Security Selection for Fixed Income Clients
We do not consider events surrounding the downgrade of U.S. Treasury securities warranting a change in our current investment themes or our management of fixed income portfolios. We continue to believe that the fixed income markets have benefited from extraordinarily low interest rates. Our view specifically regarding the 10-year Treasury is that nominal and inflation-adjusted yields are unattractive. Therefore, we remain cautious but are continuing to find bottom-up oriented opportunities as we have found right through the crisis.
Volatility Will Be the Norm in the Near Term
The behavior of the equities markets today—with the North and South American benchmarks down between 4.04% (Canada) and 8.08% (Brazil)—is not related to S&P’s action on Friday. The U.S. market weakness followed markets in Europe where investors became anxious over the real prospect that Spain and Italy would require European Central Bank support to pay their debts beyond the token advances the Bank made last week. French and German banks, which hold sizeable amounts of these nations’ debts, fell between 4.00% and 8.00%, more than the country benchmarks. The impact was interpreted to mean lower euro zone growth and therefore lower U.S. exports to Europe as well as an added headwind to China accelerating its growth following several quarters of inflation fighting austerity. In our view, these factors threaten American jobs.
It is perhaps fortunate the Fed’s main policy group will meet tomorrow. With Congress incapable of taking decisive action it is again up to the Fed to reassure markets so that today’s fears do not spin downward and lead to a full-blown recession.
The Downgrade Forces Clarity
Our view is that the downgrade does matter, but not for the reasons the headlines shout. It matters because the political choices before our leaders are now stark. The U.S. cannot continue to borrow $0.40 for every dollar it spends. We hold on to the view that politicians will place reality above ideology and work to devise policies that lead to a less-intrusive government, that promote growth policies guided by clear regulations, and that strengthen the U.S.' long-held comparative advantages in technology, finance, education, healthcare and industrial processes, among others. The markets and their constituents will no doubt help to focus this clarity.
As always, we invite you to reach out to your Fiduciary Trust contact if you have any questions or if we can help you in any way.
Information and views are as of August 8, 2011 and for illustration and discussion purposes only. This should not to be construed as investment advice or an offer for a particular security. Our investment strategies and the resulting portfolio holdings may change depending on factors such as market and economic conditions.
Our Expert Professionals
Vice Chairman and
Chief Investment Officer
Ronald Sanchez, CFA
Director of Fixed Income Strategies
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