Beyond Bulls & Bears

The U.S. Credit Downgrade

You might be forgiven for thinking that you’ve just woken from a three-year coma: To many investors, the steep market declines of recent days have echoes of September, 2008. But today’s volatility has different roots – and presents different challenges. Friday’s S&P downgrade of the long-term U.S. sovereign credit rating only added to a growing list of concerns. In the excerpted conversations with Franklin Templeton investment professionals below, we’ll explore the current market environment, where there are challenges, and where there may be potential opportunities for savvy investors.

On the causes of the downgrade:

Few attentive investors doubted a U.S. credit downgrade was possible. Anyone following the U.S. debt ceiling debacle saw American politics hit an ugly new low – even as S&P warned that policymakers needed a viable consensus for significantly reducing the national deficit. As Roger Bayston, Director of Fixed Income for the Franklin Templeton Fixed Income Group®notes,

Roger Bayston
Roger Bayston

“News of the U.S. long-term sovereign credit downgrade by Standard & Poor’s (S&P) to AA+ from AAA on August 5, 2011, was not entirely unexpected. On April 18, 2011, S&P changed its outlook on U.S. debt to “negative” from “stable.” Furthermore, on July 14, 2011, S&P placed the U.S. on a Credit/Watch Negative warning. According to S&P, these actions were prompted by the U.S. government’s lack of ability to agree on a viable plan to reduce the country’s deficit over the long term.”

On the downgrade’s fixed-income impact:

Ed Perks
Ed Perks

But if the causes of the downgrade are reasonably clear, its repercussions are not yet. Monday’s 600+ point equity sell-off coincided with a rallyin Treasuries – the very assets which S&P just downgraded. Ed Perks, Director of Core, Hybrid Portfolio Management for the Franklin Equity Group® says in a recent interview that this reaction actually made sense,

“I think you have to think about the broader fixed income markets. The U.S. still is very much the most liquid bond market in the world, and that certainly is very relevant. I think also the result of some of the actions the last couple of weeks has been a downgrade to some extent of economic growth expectations, of inflation expectations. So, that also has led to a rally in Treasuries, which has seen the yields decline even further.”

On other repercussions of the downgrade:

Other repercussions of the downgrade may take more time to become apparent. Perks and Bayston agree that a modest increase in interest rates is likely, as modestly higher borrowing costs for the U.S. eventually set-in and trickle-down to corporate and individual borrowers. And downgraded Treasuries meant that government-sponsored entities Fannie Mae and Freddie Mac felt the same fate. Some have wondered whether the downgrade would mean the portfolios of institutional investors would shift dramatically. But Bayston doesn’t believe there will be a dramatic change in asset allocations:

“We would expect to see some portfolio asset shifting in the marketplace as a result of the downgrade, because there are various types of institutional investors with credit restrictions. The exact amount of these changes is unknown. And the ratings changes for U.S. Treasuries may impact other sectors that have actual or implied U.S. government backing. However, we do not anticipate major asset allocation shifts as a result of this downgrade.”

The downgrade and the U.S. economy:

There are good reasons to believe this correction is different from 2008. As Perks notes, declining commodity prices may help consumers, and corporate credit growth is rebounding, so credit markets are less likely to seize, as they did then. Ed Jamieson, President and C.I.O. of the Franklin Equity Group®, believes there are other reasons to be optimistic about the economy:

Ed Jamieson
Ed Jamieson

“Many corporations have significant exposures to emerging markets, so even though our economy is anemic and weak and we’re not seeing a lot of growth, corporate earnings have been able to grow quite smartly. Housing affordability, because house prices have come down, is at an all-time record high. Just six months ago we had a disruption in auto production; auto production is now back on its feet at its regular levels, so that should show a jump in GDP. Another factor is the consumer…the consumer has been paying down his and her debt over the last few years, and as a result, debt service requirements for the consumer are now back to what they were over a decade ago.”

On the potential for additional stimulus:

If you’re in the camp that believes government stimulus can help the economy, you may have even more reason for optimism. The Fed announced Tuesday that it will maintain its near-zero interest rate policy through mid-2013. And rumors of QE3 continue. But Perks argues that if the Fed does try QE3, it needs to find a way to make its effects more targeted for businesses and consumers:

“…There was a lot of debate as QE2 was ending about how effective was it –, certainly it was in terms of keeping long-term interest rates low. You can argue whether it was effective in terms of really helping the economy or helping consumers. I’m not sure that translation was there. So I think to the extent that policy-makers do engage, it must be targeted in a way that can really be productive, either for businesses in the U.S. or for, ultimately, consumers.”

If all this sounds a bit confusing, it’s because it is. As Bayston notes, we’re in a bit of uncharted economic territory. But unexpected market changes are nothing new, and Franklin Templeton has successfully navigated through many. As events unfold, Beyond Bulls and Bears will continue to regularly bring you their investment professionals’ experienced, long-term perspectives. As the late Sir John Templeton said,

“It is well to remember that both bear markets and depressions are temporary. People do not remain pessimistic forever.”

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