Weekly Market Commentary August 8, 2011

Downgrade gloom hangs over markets

What a week. The MSCI All Country equity index plunged 8.6%, capping a two-week decline of 11.2%. The slide peaked on Aug. 4, when the index fell 4.1%, on worries about economic growth, debt crises and political dysfunction. And then on Friday, after the July employment report wasn’t as bad as feared, there was a brief moment of stability. Unfortunately, it didn’t last long. On Friday evening, Standard & Poor’s downgraded the credit rating of long-term U.S. government debt to AA+ from AAA.

The most interesting aspect of S&P's decision was its assessment of the political climate, rather than fiscal conditions, as its primary justification. Make no mistake, the country’s debt burden is high and growing and that is the problem. But S&P chose to downgrade, and do so now, because of their loss of confidence in the ability of the political process in Washington, D.C. to deliver a credible plan of deficit reduction sufficient to stabilize and reverse the growth in the nation’s debt.

The first sentence of the ratings rationale reads: “We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”

Neither was S&P sufficiently impressed by the budget deal that just passed in conjunction with the increase in the debt ceiling. As it warned back in mid-July, $4 trillion in deficit reduction was needed to stop the debt spiral, not the $2.5 trillion deal that we got. But these are the same set of circumstances with which the other two rating agencies are confronted, and Moody’s and Fitch have chosen to leave their ratings at Aaa and AAA, at least for now. They are taking a wait and see approach — waiting to see what comes out of this so-called “super committee” and how the process plays out. Standard & Poor’s, on the other hand, has said they’ve seen enough. In their view, the fight over the debt ceiling displayed such a level of dysfunction that it drove them to conclude that a deal sufficient to justify the retention of a AAA rating was not going to happen.

The consideration of political issues alongside fiscal conditions is an established part of the rating methodology. In rating sovereign credits, Standard & Poor’s identifies five key factors, the first of which is institutional effectiveness and political risks. The other four are economic structure and growth prospects; external liquidity and international position; fiscal performance and flexibility, as well as debt burden; and monetary flexibility. So the focus on politics, against a background of fiscal weakness and monetary inflexibility, is understandable. But it is also a little surprising. Could they have justified waiting until November to see what actually happens, rather than assuming what will, or rather won’t, happen? Yes. But not in their minds. They felt otherwise.

In the ratings report, Standard & Poor’s outlined the debt problem under a range of conditions and identified three possible outcomes. Its base case scenario, which is consistent with a AA+ rating and a negative outlook, estimates that U.S. GDP will average 3.0%, inflation 2.0%, debt to GDP will end 2011 at 74% of GDP, and then grow to 79% in 2015 and 85% in 2021. This scenario assumes that the Bush tax cuts are extended beyond their current expiration date in 2012. Even though they are scheduled to expire, Standard & Poor’s said because of the Republican party resistance to any revenue raising measures it must be assumed that the tax cuts will be extended. This is the most curious part of the decision to downgrade. S&P may be right, and nothing big enough will get done. Certainly Congress has done nothing to discourage that view. But, in my mind it is premature to change a rating based on something you assume will happen, but might not. Politics makes strange bedfellows and compromise can happen at any time. Why not wait until November and then decide based upon what actually happens?

Standard & Poor’s upside scenario, which is consistent with a long-term AA+ rating that is revised to stable, and makes the same GDP and inflation assumptions, and assumes the Bush tax cuts do expire, shows debt to GDP rising from 74% in 2011 to 77% in 2015 and 78% by 2021.

The downside scenario, which is consistent with a possible downgrade to AA, assumes weaker economic growth of just 2.5% and inflation of 1.5%. It also assumes that the minimum automatic cuts of $1.2 trillion that the deficit deal requires do not happen. This scenario shows debt as a percent of GDP rising to 90% in 2015 and 101% by 2021.

It is clear that Congress still has a lot of work to do to maintain even a AA+ rating. And only a “grand bargain” of $4 trillion or more would get us headed back toward a AAA. It can be done. According to Bloomberg, since 1980 five countries have managed to lose and earn back a AAA rating. Canada did it the quickest and it took them nine years.

How the downgrade will affect asset prices in unclear. Interest rates should be expected to rise, all else being equal, although history suggests not necessarily. The dollar should weaken and gold should rise. Equity prices are already under severe pressure and this will not help. Technicians agree that severe damage has been done to equity markets over the past two weeks and equities remain vulnerable. For the S&P 500, which closed last week at 1199, near-term support resides in the vicinity of 1170 and below that near 1120.

Michael Mazzilli, is a local Private Wealth Advisor with Ameriprise Financial Services, Inc., based in Mamaroneck, NY.