18th April 2011

F&C: S&P downgrades its rating on US debt from stable to negative

What has happened
Both bond and equity markets received a nasty shock when the credit rating agency announced it was downgrading its rating outlook on US debt to negative today. For the last 18 months or so, the focus of attention has been on the growing sovereign debt crisis in the Eurozone but the elephant in the room has always been the US, the world's largest economy with a deficit estimated to reach $1.5trillion by the end of the year.

Why the US deficit is important

To date, the US economic policy has been in contrast to what governments have been pursuing in Europe with regard to tackling the long standing debt problem while trying to prevent the economy from relapsing into recession. In the Eurozone and the UK, politicians have accepted that a period of austerity is a necessary price to pay to reduce government borrowings and have implemented fiscal programmes of varying degrees of severity that will hurt aggregate demand and GDP growth. In contrast, the US, via both its aggressive monetary policy and fiscal measures involving tax cuts under both Bush and Obama, has endeavoured to grow its way out of its fiscal deficit problem in the hope that a stronger economy will lead to higher tax revenues and lower government spending as employment rises.

To some extent, the US policy has been vindicated as the economy has recovered at a faster pace than most other developed economies and, more recently, the rate of unemployment has begun to fall. At over 10%, the unemployment rate was at a political unacceptable level and while it has now fallen below 9% the Federal Reserve and government would still regard it as far too high. Inflation has also risen from dangerously low levels that threatened to morph into deflation that could have become endemic, something that the Fed in particular feared. The policy of QE, by creating extra liquidity, has contributed to rising prices as surplus money as chased asset prices, especially commodities, higher.

However, such a policy, both fiscally and monetary, has been hugely controversial. The US has been accused of mortgaging its future by providing a sugar rush to the economy now that merely brings forward growth today at the expense of delaying the day of reckoning to deal with the country's ballooning debt to a later date. In recent weeks, the politicians of both main parties have recognised that the current situation is unsustainable and that it was important for a credible plan to be formulated to tackle the deficit.

Recent developments to tackle the deficit

Although there is a Democrat President, the Republican party control the House of Representatives and have drawn up a deficit reduction plan to reduce the deficit by $6.2bn over the next 10 years. This proposes large spending cuts, especially in the areas of health and social programmes that the Democrats have accused the Republicans of hitting the elderly and poor too hard. The bill has been passed in the House but is unlikely to be approved in the Senate that is controlled by the Democrats.

Last week, the President outlined his alternative plans for tackling the deficit. The aim is to cut the deficit by $4trillion by 2023, 2 years later than the Republican plan. Unlike the alternative, Obama envisages spending cuts in other areas such as defence combined with tax rises, mainly on the wealthy. Although, the broad outline of the 2 plans are not dissimilar the different road maps to achieving the cut in the deficit are far apart and could lead to a political impasse.
It is this fear of a lack of political consensus that led to S&P downgrading its rating outlook today as much as the state of finances itself. It said in its release that 'if an agreement is not reached by 2013, it would render the US fiscal profile meaningfully weaker than its peer AAA sovereigns''. S&P also said it could "lower [their] long term rating on the U.S. within two years'' that is earlier than analysts were expecting.

Market reaction

The markets were caught by surprise by today's announcement at a time when analyst's had been downgrading growth expectations for the US, mainly as a result of poor weather in Q1 and higher commodity prices. The downgrade is, however, only in the outlook and is unlikely to lead to a cut in the rating itself. Indeed, it should focus the mind of the politicians of all parties to agree a credible debt reduction plan now that the clock is ticking on its debt rating.

The last time a rating agency downgraded its outlook on US Treasuries was in January 1996. Then, 10 year yields rose by 9bps the next day but the sell off was quickly reversed Although the situation is a lot more grave today than in the mid 1990's I would expect the sell off today to be a similar buying opportunity, especially for equity markets that have sold off slightly in the last fortnight.

Ted Scott April 2011

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