Market Update on S&P Downgrade of U.S. Debt

by Marilou Long on August 8, 2011

in Banks,Crossvault Capital,Debt,Fiscal Policy,Foreign Markets,Investment Strategies

As the effects of the S&P downgrade of U.S. sovereign debt to AA+ are being felt across global markets, we wanted to give you our assessment of what the downgrade and recent market volatility means for your portfolios. As we’ve discussed with you often since the financial crisis, deleveraging is a slow and difficult process whether for individuals, institutions, or nations. Europe is several years behind us in dealing with all the bad debt in its banking sector, and the ongoing turmoil in the EU was one of the main factors leading to this summer’s market decline. We have had much higher than normal cash levels since the spring when we began to get stopped out of some of our equity positions. In addition, we have not been comfortable with either the market action or the macro-environment surrounding Europe and the debt ceiling battle here at home. The downgrade by Standard and Poor’s was signaled for months, and the fact that it actually happened is the explicit realization that our political decision making process is deeply flawed. S&P even stated that they needed to see $4 trillion in cuts in order for the U.S. to keep its AAA rating. From the press release issued by S&P on Friday: The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change

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in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability. There are three main effects of the downgrade; two are negative and one is positive. On the negative side, market volatility will increase over the near term as risk gets repriced. Also, the chance of the domestic economy sliding back into recession has gone up since corporate managers may further delay spending decisions that have already been postponed due to regulatory, political, and taxation uncertainty. On the positive side, this is the first time in our lifetime that both political parties have acknowledged that continually increasing government spending and funding it with debt is not prudent or sustainable. Our primary goal as always is to protect your portfolio while positioning it for future growth. High cash levels and low equity exposure combined with the bonds in balanced accounts helps the portfolio during periods of market volatility. However, we do not think that this is a similar period to the financial crisis of 2007-2008. Our domestic banking system has been recapitalized, corporate balance sheets are strong, rates are low, and falling energy prices will help the consumer and businesses. If both Congress and the Administration can focus on creating jobs rather than name calling, our economy may be able to get through this period of low growth without slipping back into recession. We would also like to see stability in European sovereign debt spreads in order to become more positive on the market.

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