Equity Commentary: S&P Downgrades U.S. Credit - What it Might Mean For Equity Markets
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
This was a very eventful week in the markets with significant volatility in equity and commodity markets globally, culminating in U.S. Debt downgrade from an AAA to AA+ by S&P after the markets closed on Friday.
S&P stated that it is "pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon." The decision came before the expected appointment of the "super-committee" which is tasked with coming up with a recommendation for second stage budget cuts of $1.5 trillion.
At this time of market distress, S&P's negative outlook and downgrade of U.S. debt from AAA to AA+ may add to market volatility and further depress investor sentiment while potentially instilling better discipline into policymakers in the long run. This leaves J&J and Exxon with higher debt ratings than U.S. Treasuries. In the long run the downgrade is likely to raise the cost of capital for U.S. paper, however, in the short term, U.S. Treasury yields may go down as risk aversion in the markets increases and investors bid up Treasuries as a safe haven asset. This is the first time in U.S. history that its credit rating has been downgraded.
The downgrade may present an additional shock to investor confidence and cause equity markets to sell off further next week. One of the unintended consequences of the move by S&P could be that austerity measures are implemented in the U.S. sooner rather than later, increasing the risk of a double-dip recession which in turn will further dampen the U.S. credit outlook.
The Federal Reserve board reacted on Friday night after S&P's announcement by stating that risk weight of agency debt will not change and that the risk capital calculations of the banks will not be impacted as a result of the downgrade by S&P of U.S. long-term rating. There will also be no implications for the discount window, effectively assuring the markets that the Fed will stand by the banks (accept collateral etc.) if there is financial market turmoil on Monday.
While QE3 hasn't had a lot of support until now, if markets decline and accelerated austerity measures threaten to tip the U.S. economy into double-dip recession territory, additional stimulus may be forthcoming.
U.S. debt is now split-rated with one out of three credit agencies rating U.S. debt below triple A.
During the week there was significant movement by institutional investors into cash as they took risk out of their portfolios; this was met with unprecedented new charges on their deposits by custodian bank, Mellon, prompting higher demand for Treasuries.
Deleveraging will need to continue in both public and private sector.
The European Union debt crisis uncertainties continued throughout the week as were the worries about anemic economic global growth which saw U.S. GDP growth numbers revised for H1 to an approximate 1% average annual growth rate. With the measure to cut more than $2.1 trillion from federal budget enacted earlier in the week, the impact of the debt ceiling deal on GDP growth is expected to be negative and could amount to as much as 1% hit.
The earnings season, while positive, is ending and no longer acting as a positive catalyst for the Equity markets. More than 75% of companies in the S&P 500 reported better than expected earnings in the second quarter. More impressive, revenue forecasts for many companies during the quarter were also exceeded. Although future guidance from many companies was negative as companies remain cautious and conservative in their projections.
ISM manufacturing numbers, while still in expansionary territory, decreased to a two-year low indicating that the engine of the economic recovery is still slowing. This, anemic consumer spending and the likely slow down of government spending is reigniting investors’ worries about the possibility of a double-dip recession. During the week, the release of June consumer spending data reflected a 0.2% decline.
Employment report numbers came in better than the consensus estimate of 85,000 on Friday showing that U.S. employers added 117,000 workers in July compared to 46,000 in June. The unemployment rate inched back down to 9.1% owing primarily to larger numbers of discouraged workers leaving the labor force.
On Friday, President Barack Obama called for a temporary payroll tax relief to boost employment and advocated further extension of unemployment benefits.
We believe that based on fundamental economic data the U.S. economy has a good shot at recovery in the second half of the year and can avoid a double-dip recession. However, if the negative investor sentiment results in further panic selling in securities markets and political reaction to the downgrade of the U.S. debt forces the spending cuts to come too soon, a double-dip recession could become reality.
While we recognize that the risks to the downside are now heightened and that our cautiously optimistic stance is now in the contrarian camp, we still place a higher probability on a slow recovery than on the double-dip scenario at this point and believe that decreasing Equity valuations in the short run can present attractive investment opportunities for long-term investors. Last year, S&P hit a low in August on double-dip concerns and rallied 20% from those levels through the end of 2010 following announcement of QE2 by the Fed. There are still both fundamental and policy catalysts that can produce a similar outcome.
This commentary represents the opinions of its author as of 8/6/11 and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
Calvert Investment Management, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814