The Downgrade
Despite passing the debt ceiling and spending cut deal anticipated by the markets, last week’s data and events pulled bond yields lower and left theS&P 500 now down about 10% from this year’s high. This slide may seem all too familiar. Market participants are worried about a repeat of the 2008financial crisis. While the message from the markets is important, in last summer’s soft spot the 10-year Treasury note yield fell below 2.4% and thestock market fell 15%, but no recession took place. Instead, as the market became too pessimistic on the prospects for growth in the second half ofthe year, stock returns and bond yields moved to new post-crisis highs. Thesummer of 2010 is the more relevant comparison to the current market slide than the summer of 2008, in our opinion.
Friday’s news that one of the three U.S. rating agencies was downgradingthe U.S. credit rating from AAA to AA+ hit the markets and sapped thegains fueled by the report of better-than-expected job growth in themonth of July (and positive revisions to prior months). As the rumorsof a downgrade hit, stocks slumped. Is this a killing blow for a market and economy already suffering from a series of disappointments or adisappointing but lagging indicator of the pressures already reflected in themarket’s path and level of recent years? We favor the latter assessment.
Here we will present our views on the downgrade from; why it happenedand what it means for investors and policymakers, and what is next forthe markets. For more insight, please see the Bond Market Perspectivespublications from July 19 and August 2 where we discussed the details surrounding the pending downgrade.
Why did it happen?
While the imbalance in the U.S. long-term fiscal situation is no mystery,the reasoning for the downgrade at this time is best left in the words ofStandard and Poor’s. The first news of a near-term potential downgradecame on April 14 of this year. Standard and Poor’s rating agency stated,“We believe there is a material risk that U.S. policymakers may not reach anagreement on how to address medium- and long-term budgetary challengesby 2013; if an agreement is not reached and meaningful implementationis not begun by then, this would in our view render the U.S. fiscal profilemeaningfully weaker than that of peer ‘AAA’ sovereigns.”
On July 14, the outlook for a downgrade became even clearer as Standardand Poor’s clarified their position with the statement: “The CreditWatchWeekly Market Commentary LPL Financial Member FINRA/SIPC Page 2 of 6placement of the U.S. sovereign ratings signals our view that, owing to thedynamics of the political debate on the debt ceiling, there is at least a one-intwolikelihood that we may lower the long-term rating on the U.S. within thenext 90 days.” Standard and Poor’s cited $4 trillion in savings as part of thedebt ceiling bill as the number that would be a trigger to avoid a downgrade.As it became apparent that a “grand bargain” of around $4 trillion was off the table, a downgrade by Standard and Poor’s became likely.
On Friday, August 5, the rumor of a downgrade announcement negativelyimpacted the markets. The announcement of the downgrade was delayed bythe Treasury pointing out an error to Standard and Poor’s in their calculationsof $2 trillion as it related to the size of the total debt-to-GDP ratio which was aprominent component of their economic justification for the downgrade. S&Packnowledged the error and removed that component and focused on thepolitical environment for the justification for their downgrade
