What To Do About the U.S. Credit Downgrade

On Friday, Standard & Poor’s lowered the credit ranking of the United States from its most creditworthy status of AAA to AA+. This is the first time in history the United States has been lowered. As a result, the stock market tumbled with the S&P 500 down roughly 6.7% for the day. Here are my thoughts on the situation:

• The announcement of the downgrade by Standard & Poor’s simply reflects what is already known. The creditworthiness of the United States is still strong, but we have structural issues with our fiscal policy that need to be addressed. The only new news was the announcement. This created no surprise to me.

The ramifications of a downgrade would suggest that interest rates would increase as buyers of United States bonds would require a higher interest rate as compensation for more risk. Ultimately the market would decide this, but given the weak economic conditions around the world, I doubt that rates will rise quickly in the near future. Japan was downgraded earlier this year and no one flinched.

• The other concern would be the loss of the dollar as the reserve currency of the world. But it begs to ask, what would replace the dollar? The only remaining “real” AAA rated countries are too small to handle the volume or do not want to assume this implied leadership. The Chinese want our dollar strong so they can continue to sell stuff to us at affordable prices. The Euro is worse off and there is not enough gold in the world. The United States economy is weak, but it is still the largest and strongest economy in the world and our largest companies are still quite profitable. Ironically Treasuries rose yesterday because they are still the safe haven of the world.

The real risk is uncertainty. The announcement of the downgrade was nothing within itself. However, the consequences of the announcement and combination of reactions could potentially create a tipping point or Black Swan event, creating capitulation similar to the fall of 2008. We won’t know if this will create a tipping point or if this is a tipping point until we are looking back at this in the future. The risk of these events is always present in both good and bad times.

• Keep in mind that a country with a sovereign debt issue that can control its currency can never fall into actual default. When you control your currency, all you need to do is start printing currency and devalue the debt away. Unfortunately the cost of this is high inflation.

• A political silver lining? I think our elected officials thought they were going to get off easy last week. They thought they could do some political posturing, defend their ideology and make a last minute deal to avoid chaos and save face. Ironically it backfired because as their inability to address our debt problem in the long term created a ripple in an already fragile global economy. It’s time to address the situation rather than kick the can down the road – remember – we are the ones that vote them into office.

• The ratings agencies don’t have a great track record. A few years ago, Standard & Poor’s gave solid credit ratings to Lehman Brothers, AIG and plenty of those toxic mortgage backed securities. None of these exist anymore. Billionaire Warren Buffett, the world’s most successful investor, said S&P erred and the U.S. should be rated “quadruple-A.” I don’t know about you, but I’d trust Buffett more than Standard & Poor’s. Moody’s today also rebuked S&P’s downgrade.

• Unless there is some unforeseen tipping point as discussed above, I believe the reaction of the markets were more emotion and animal spirits than based on fundamentals. And the financial press does not help quell that fear because sound investing principals don’t generate great ratings. As discussed the other day, if the market continues to give you trouble, one of the best things that you can do is periodically rebalance your portfolio. This is nothing sexy, but rebalancing forces you to buy low and sell high.

Finally, no matter how scary it might seem, this is atypical market behavior. If you allow yourself to be swept away by Mr. Market every time a blip occurs, you will not be very successful over time. If you allow yourself to work with the things that you can control and be opportunistic of what the market brings you, a contrarian investment strategy can be very rewarding.

About the author

Jeffrey N. Bogue, CFP®

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