One page guide: What to tell clients on US downgrade

The historic downgrade of US debt capped a momentous week which saw global markets go into free-fall.

With emotion running high and the jury still undecided over whether we are witnessing a momentary blip or something more sinister, IFAonline tries to make sense of it all for you and your clients...

Background

After markets closed on Friday, ratings agency S&P downgraded the US government's prized AAA-credit rating to AA+ for the fist time in its history.

The historic but widely anticipated move capped one of the most volatile weeks markets have seen for years as political grandstanding over the US debt ceiling combined with Euro contagion fears to send markets into freefall.

London's FTSE shed 10% last week and 2.7% on Friday alone.

Asian markets continued the sell-off today, with Japan's Nikkei 225 index plunging 2.4% and South Korea's Kospi losing 5%.

Why US rating was slashed

The reason for the downgrade was as much political as economic, with US politicians recently playing a dangerous game of brinkmanship with the country's finances.

The ratings agency cited the country's failure to embark on a clear path to reduce its huge deficit. It felt last week's deficit reduction plan failed to go far enough to safeguard its finances. 

And the country is clearly living beyond its means, with its level of debt now topping $14.6trn.

But whilst the US downgrade made some dramatic headlines - with the superpower now rated lower than Guernsey, the Isle of Man and Hong Kong - the writing has been on the wall for some time.

All three major ratings agencies have kept a close eye on the US debt situation for months, warning of an imminent downgrade unless it got its house in order.

What does it mean?

In essence it is a largely symbolic move, according to many analysts. They argue whilst it will serve as a useful wake-up call to squabbling US politicians, its impact will be minimal.

Markets are largely driven by emotion and panic selling can often put in motion a downward spiral of fear. In the euro debt crisis the oft-repeated phrase ‘fear of contagion' is more a contagion of fear.

Although some point out the perceived increase in the risk of the US defaulting could result in the country paying more to borrow, many economists think the downgrade will have little, if any, impact on borrowing costs.

The chances of a US default are, in reality, very slim.

Indeed since the downgrade, yields on 10-year Treasuries have actually fallen five basis points as investors continue to pile into safe havens.

There have been concerns S&P's downgrade could result in a jump in interest rates - something Capitol Hill will be keen to avoid given the country's stalling economy.

But again, this is by no means a certainty. After Japan was downgraded in 2001 it actually saw a fall in interest rates and the country still enjoys very low rates.

In addition, the Federal Reserve could unleash a new round of quantitative easing - something it hinted at recently - in an effort to keep rates low.

Role of ratings agencies

The whole affair could turn out to be more harmful to the reputation of ratings agencies and further bring them under the spotlight.

Fears have surfaced recently that agency warnings and downgrades have effectively become self-fulfilling prophesies.

Moody's downgrade of Portugal's debt to 'junk' status last month led to criticism from the European Commission which questioned the role and behaviour of ratings agencies.

The fact S&P over-calculated US debt to the tune of $2trn in a document sent to the Treasury before its downgrade will no doubt invite further criticism.

Reaction

Legendary investor Warren Buffett said S&P made a mistake in lowering the US credit rating, reiterating his view the economy will avoid its second recession. According to the Sage of Omaha, the US merits a "quadruple A" rating.

But against this, PIMCO's star bond manager Bill Gross told Bloomberg the ratings agency's downgrade showed "spine".

What now?

With the US downgrade coinciding with last week's dramatic plunge in global stocks, investors have clearly taken fright.

But the message from advisers seems to be one of "Do not panic". The turmoil in the markets last week seemed less the result of any new information coming to light and more the confluence of a range of toxic issues including Euro debt concerns, US debt challenges and signs of slowing global growth.

Whilst advisers have been keen to talk up the importance of having a balanced portfolio with allocations to defensive assets including gilts, they have also stressed the short-term nature of the fallout and the buying opportunities on offer.