What does US debt downgrade mean for global markets?

8 August 2011

After a week of falling global sharemarkets in response to heightened concerns over the global economic outlook, investors would have been buoyed by a better than-expected US labour market report on Saturday morning (Australian time). However, by now investors would be aware that the United States lost its AAA long-term credit rating after being downgraded by ratings agency Standard & Poor's (to ‘AA+’).The short term rating of A-1+ has been affirmed.

What is a credit rating and what does a rating of ‘AA+’ indicate?

• A credit rating is a forward-looking opinion an agency has about credit risk and the issuer’s ability and willingness to meet its financial obligations in full and on time.
• A rating of ‘AAA’ (which is the highest possible rating) indicates that the issuer has an ‘extremely strong’ capacity to meet its financial commitments, whereas a ‘AA+’ rating means the ability of the issuer to meet this obligation is classified as ‘very strong’.

What was the rationale for the downgrade?

The downgrade reflects Standard and Poor’s opinion that:

• The recent fiscal consolidation plan agreed to by US Congress and the Obama Administration fell well short of what Standard and Poor’s believed was necessary to stabilise the US Federal Government’s medium term debt dynamics (see stats in Table 1).
• The inability of Congress to frame a consensus comes in 'an era of (required) fiscal stringencprivate sector deleveraging'. They state that ‘(recently revised GDP) data highlight the sub-par path of the current (US) economic recovery when compared to the rebounds following previous post-war recessions. (They) believe the sluggish pace of the current economic recovery could be consistent with the experiences of countries that have had financial crises in which the slow process of debt deleveraging in the private sector leads to a persistent drag on demand.'

What does this mean for financial markets?

• The US government bond yield is a key component every asset’s price. In his July testimony before US Congress, U.S. Federal Reserve Chairman Bernanke stated ‘If investors can't count on the safety of U.S. debt, they would ask for higher interest on that asset class, pushing up the interest rates on other assets'.
• However, it is hard to precisely gauge how much US interest rates (and global rates) will move by due to the downgrade because only one age an impact on market interest rates.
   
• It is unlikely that US interest rates will spike massively higher as US capacity to meet its financial commitments is still ‘very strong’, the US bond market is still the most liquid in the world and is backed the productive capacity of the US economy (which produces USD15 trillion of year) and other AAA-rated markets are much smaller than that of the US. In addition, the impact of a downgrade on other AAA rated countries in the past has been modest.

What does it mean for your portfolio?

For our Australian equity funds:

• Perpetual never loses focus on investing in companies with sound management, quality businesses, a balance strong sheet and a history of recurring earnings. Quality companies like these have consistently outperformed during periods of market stress.
  
  
  • Perpetual constantly looks for value in the market and buying opportunities, often present during markets like these.
• Investors using a Perpetual managed fund should take comfort in a robust risk managed investment process, designed for both up and down markets.
  
  
  • Perpetual has a history of outperforming in down markets.

For our Australian credit funds:

• The fixed income exposures we manage for clients are largely invested in Australia. We predominantly lend to Australian Governments, good quality Australin companies and Australian home-owners.
  
  
  • Australian borrowers have generally had lower cumulative default rates than global peers and having exposure to Australian dollar denominated assets mean much lower volatility in the cash we can distribute;
  • We have no exposure to US sovereign debt and little exposure to sub-investment grade; and
  • We invest primarily in shorter dated securities that provide better certainty on the return of capital.
• Despite this, we are currently being cautious:
  
  
  • Our credit funds currently have a credit score of -1 as part of our credit outlook. This scoring process assesses and help us to manage the level of risk we should have in our portfolios. The scoring ranges from -4 to +4. The score of -1 largely reflects high oil prices and weak equity markets. However, manufacturing and credit growth and more credit rating upgrades to downgrades prevent us from a more bearish outlook.
• There will be a fair degree of volatility associated with current conditions and the quality of underlying assets will be important for preserving capital. The ability to take advantage of emerging value opportunities through active management is very useful also.
  
  
  • There is still good value in Australian asset back securities and local banks, and the running yield on our flagship Perpetual Diversified Income Fund is still about 2% above the cash rate.
  • Given the modest weighted average life (the average length of the lending in the portfolio), there is a reasonable degree of visibility to this outcome over the medium term.

 
Disclaimer

This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for financial advisers only. It is general information only and is not intended to provide you with financial advice. The views expressed are the opinion of the author at the time of writing and do not constitute a recommendation to act. Any information referenced is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.  Past performance is not indicative of future performance.