Wednesday, August 10, 2011

S&P Lowers US Debt Outlook - Implications For Investors

Following S&P's lowering of its outlook on the US sovereign debt rating to "negative", what implications should investors be aware of?

Key Points:
* S&P lowered its long-term US sovereign credit rating from “stable” to “negative”, while retaining its AAA rating on US sovereign debt.

* A negative outlook is not equivalent to a downgrade.

* Similar circumstances occurred in 1995-1996, where issues over the US budget led to a temporary government shutdown, and credit rating agencies lowered their outlook on the US sovereign debt rating.

* Even if a downgrade does materialize, US sovereign debt should still remain high investment grade, still extremely unlikely to go into default

* We identify three main implications should a downgrade arise:
o Bond yields likely to rise
o The US dollar may weaken, and may become more volatile
o Heightened risk aversion may be expected, but is likely to be a temporary phenomenon; May provide a buying opportunity for risky assets

What Has Happened?
On 18 April 2011, Standard and Poor’s (S&P), one of the “big-three” credit rating agencies, affirmed its AAA (the highest possible) rating on long-term US sovereign debt, but lowered its outlook on the long-term US sovereign credit rating from “stable” to “negative”. According to S&P, this indicates that the US sovereign credit rating may be lowered over the next 6 to 24 months.

As key negatives, S&P cited the “very large” budget deficit of the US along with “rising government indebtedness” as concerns, while the recent political gridlock over proposed government spending cuts to address budget challenges over the medium- to long-term has also given S&P some cause for worry.

Quick Comments?
Amidst much fear mongering in the media over S&P’s latest move, we wish to highlight several important points. First, investors should note that S&P’s negative outlook is not equivalent to a downgrade. It merely represents a potential lowering of the US sovereign debt rating in the future (S&P continues to rate US sovereign debt as AAA), should current issues (namely the ongoing political gridlock over the US budget) fail to see resolution over the medium term. There is, of course, the possibility that US politicians may come to an amicable agreement to address longer-term budgetary concerns (which stands up to S&P’s scrutiny), thus allowing the US to avoid a rating downgrade.

Second, while investors have generally been surprised by S&P’s latest announcement, this is not the first time a credit rating agency has lowered its outlook for US sovereign debt. Fitch Ratings had placed US sovereign debt on “negative ratings watch” in late 1995, while Moody’s Investor Services placed US$387 billion in Treasury bonds “on review for a possible downgrade” in January 1996. These negative outlooks also came as a result of political gridlock: Then-President Bill Clinton (a Democrat) and the Republican-led Congress were unable to come to a compromise over the budget, which led to a temporary government shutdown in November 1995.

Third, it must be highlighted that even if the US sovereign debt rating were to be lowered, this would not be tantamount to a default. Should a downgrade be required, the US sovereign rating would likely fall by a notch to AA+ (from AAA), which, according to S&P’s rating system, still represents an entity which has a “very strong capacity to meet financial commitments”.

Potential US Sovereign Debt Downgrade: Implications for Investors
In our opinion, S&P’s latest announcement is nothing new; the large budget deficit of the US has been highlighted as an issue by investment experts for many years. In addition, the implications we highlight in response to a potential downgrade of US sovereign debt are generally consistent with our current view on fixed income. We look at some potential implications for investors:

1. Upward pressure on Bond Yields
A downgrade of the US sovereign rating would suggest upward pressure on bond yields, which is consistent with our view that bond yields are likely to rise in the future. AAA-rated securities are perceived as having the lowest default risk, and as a result, provide the lowest returns (in the form of low yields). Should US sovereign debt be downgraded, investors may view the risk of default as having increased, and may demand higher yields on US government debt. In addition, rising sovereign bond yields have negative repercussions for other fixed income instruments, as their yields are measured in relation to sovereign yields.

Admittedly, sovereign bond yields have not always fallen following a credit downgrade, with Japan’s credit downgrade in 2002 a case in point. In fact, following S&P’s negative outlook report, US government bond yields actually declined, a function of heightened risk aversion rather than investors pricing in a higher probability of default. Nevertheless, sovereign yields are already near historical lows following three decades of declining interest rates, and at this juncture, we think that there is more upside risk to interest rates. In this respect, we view developed sovereign bonds as most susceptible to rising yields, while emerging market debt and high yield bonds are likely to be less affected due to their higher relative yields. We continue to recommend investors to be positioned in short duration funds which are less susceptible to interest rate risk.

2. A Weakening (or more volatile) US dollar
Should a lower credit rating be attributed to US sovereign debt, the US dollar may see near-term weakness should more sellers than buyers of US debt emerge. A downgrade of the US sovereign debt rating may call into question the US dollar’s “reserve currency” status (should a credit downgrade occur, US debt may no longer be perceived as the safest option for building reserves), which may lead to a reduction of demand for USD-denominated instruments. In addition, since the US dollar is a fiat currency (not backed by a physical commodity), the US has the option of embarking on an inflationary path (by creating money and effectively monetising part of its debt) to reduce its debt burden, a move which would be negative for the US dollar.

Currency movements are generally difficult to predict, and long-term fundamental reasoning (eg. interest rate parity) may often conflict with short-term capital flows. While there are various reasons (fiscal and current account deficit, quantitative easing) to sustain ongoing weakness in the US dollar, the USD has already depreciated against most Asian currencies over the past year, and market technicals may sometimes govern currency movements in the near-term, which has led to some industry experts calling for a rebound of the US dollar.

We avoid speculating on short-term movements of the US dollar, but investors should be cautioned that further weakness may arise should a downgrade of the US sovereign debt rating occur. Investments in the fixed income space are particularly affected by currency movements, and we continue to urge investors to consider MYR-focused bond funds to avoid the potential foreign exchange losses.

In addition, the uncertain interest rate environment coupled with increased concerns over the US sovereign debt rating suggests that global currency volatility is likely to remain high, which may provide currency funds with an increased opportunity set to generate returns.

3. Heightened Risk Aversion
Investor risk aversion may increase if US sovereign debt gets downgraded, as the perceived risk-free rate is being called into question. Along with S&P’s downward revision of the US sovereign credit rating outlook, S&P also revised down the outlook for US government related entities, highlighting the unavoidable link between quasi-sovereign entities and the government. In the case of corporate entities, there is an element of contagion risk as few corporate credits are rated higher than sovereign debt, especially in the developed world.

A downgrade of the US sovereign debt rating may hurt risky assets in the near term, but the stark difference between the US government and its corporate sector is worth a mention. While much has been made about the government’s inability to balance its budget (forecasts are for a US$1.267 trillion deficit for 2011), the US corporate sector remains extremely cash-rich with the Federal Reserve reporting that US non-farm non-financial corporate businesses held US$1.89 trillion of liquid assets at the end of 2010, the highest on record. Liquid assets were 50.7% of short-term liabilities (see Chart 1), the highest level since 1986. In addition, corporate profitability continues to be strong, with 2011 S&P 500 earnings expected to be the highest on record.

Given the difference in fundamentals, US equities still make sense from an investment standpoint. Stocks in the S&P 500 currently trade at relatively undemanding valuations (13.5X estimated 2011 earnings, as of 15 April 2011), and will become cheaper as earnings continue to grow over the next year. In addition, we do not expect the US to default on its debt, and any heightened risk aversion which is expected to arise from a downgrade will likely be a temporary phenomenon, and may provide a buying opportunity for risky assets like equities.

Non-Farm Non-Financial Corporate Sector


Source: FundSuperMart
Author : iFAST Research Team

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