August 12th, 2011
The Meaning of the U.S. Debt Downgrade
When Standard & Poor’s (S&P) took the controversial step on August 5 of downgrading the long-term debt of the United States from AAA to AA+, my immediate thought was “Why weren’t they this overly cautious when they were giving all those junk mortgage securities AAA ratings?” The question many people are asking now is, “What does this really mean for our country?” The answer is that, in the short-term, it doesn’t mean very much. On the other hand, if our government doesn’t reduce its deficit spending and repair the jobs picture in the long-term, downgrades by rating agencies will be the least of our worries.
There are a number of reasons that this downgrade is not a source of major short-term concern. Cambiar Investors has pointed out that, in the past, S&P has downgraded the debt of a sovereign nation from AAA to AA on eleven different occasions. In ten of those occasions, the debt of those countries had a lower yield one year after the downgrade. This means the market viewed the debt of these countries as less risky a year later, despite the downgrade.
Gold is at record highs, which indicates risk aversion on the part of investors. Which other securities, though, have seen their prices bid up by investors in their flight to quality? That’s right, U.S. Treasury Bills. These short-term obligations of the U.S. government are still considered the global risk-free investment and have maintained their AAA rating by S&P. It is unlikely that global investors will place their funds in the debt of other countries, despite this downgrade. The next three largest issuers of sovereign debt – the United Kingdom, France and Germany – have economic challenges of their own.
Another reason this downgrade will not sink the economy is that the overall economic picture is improving. While building products companies remain under considerable pressure, U.S. companies in other industries are doing relatively well. They are flush with roughly $1 trillion in cash. Public companies that exceeded their earnings expectations in Q2 outnumbered those which didn’t by a 2:1 ratio. Foreclosures and unemployment claims are dropping. The overall consensus among economic pundits is that there is probably only a 20-30 percent chance of the United States sinking into a double-dip recession. Dialing in all of these factors, the downgrade itself will do nothing to derail the economic recovery that is struggling to gain momentum.