Barclays Wealth: What we are telling clients on the US

From a near-term point of view the downgrade of US sovereign debt is a distraction and the actual impact on US Treasuries will likely be small, according to the chief investment officer at Barclays Wealth.

The 5 August downgrade by Standard & Poor's of the long-term sovereign credit rating of the US from AAA to AA+ has sent markets on both sides of the Atlantic into freefall.

Uncertainty over what will happen next has helped fuel the sell-offs. Aaron Gurwitz, chief investment officer at Barclays Wealth, has revealed what he is telling clients post-rating cut:

Will Treasury bond yields rise in response?

• Not necessarily. If investors were concerned about the credit quality of US debt, yields would have risen. Exactly the opposite happened.
• Worries about potential default by sovereign entities that control their own currency have a very limited effect on government bond yields.
• US bond yields will rise if the economy beats investor expectations and yields will likely decline further if it re-enters recession.

Investment Implications?

Firstly:

• From a three- to 18-month view, the downgrade is a distraction. If the US economy continues its recovery over that time, risk assets will do well and bond yields will rise.
• Active investors and portfolio managers should be prepared to respond to any adverse initial reaction, which will be more visible in stock than bond markets.
• The first effect will be psychological. Ignore any immediate adverse reaction and, if it's dramatic enough, view it as an opportunity to increase exposure to risk assets.

Secondly:

• We are not recommending any across-the-board reduction in portfolio risk at this point.
• But US Treasury yields have declined to the point where they do not make any sense. Investors should shift holdings from longer to shorter maturities - any impact on yields will be largest for longer maturities.
• Expect interest rates to rise and bond prices to decline over the next few weeks. Shortening bond portfolio maturities is a way to mitigate the adverse impacts of that.
• We will be watching for a near-term market impact on the operations of some crucial but obscure corner of the global financial system.

Why did S&P do what did it did?

• The plan for $2.1-$2.4trn deficit reduction over the next 10 years fails to stabilize the debt dynamics over the medium term. S&P now projects net general government debt will rise from 74% of GDP at the end of 2011 to 79% by 2015 and 85% by 2021.
• Wrangling over the debt limit highlighted the vast gap between the political parties, which suggests containing the growth in public debt will be harder than S&P had previously assumed.