Experts comment on recent US downgrade in credit markets: Part 3

  By Maureen Aylward

We asked our Zintro experts to comment on the recent S&P downgrade and its impact on the global markets. Clearly the markets are still reeling and shaking. Here is the first in a three part series on the issue as seen from a multitude of perspectives.

Mahesh Kotecha, a capital markets expert and an executive who once ran S&P’s sovereign ratings group, provides the following analysis:

• US Treasury securities have tightened today by five to ten bps, not widened and borrowing costs thus may fall for the US. They may of course rise in the longer term.
• The S&P rating is unsolicited and thus not paid for by the US. “I have a proposal to fix the conflict of interest in the current issuer pay rating agency model that may have contributed to the ratings debacle in the structured finance markets. It is published in Journal of Structured Finance and is on SEC website,” he says.
• Whereas it is true that rating agencies rely largely on public information for sovereign ratings, the value addition is in using public information to reach credit conclusions based on an analysis of the ability and the willingness to pay a particular borrower, taking into account appropriate peer group comparisons.
• The agencies have some access to confidential information as they do hold discussion with policy makers on plans and options. The value of this can vary from country to country and over time. In the US, it may be less valuable than in other countries as the policy makers in the current administration have clearly been unable to make policy due to the gridlock in Congress.
• It is a pity that S&P flubbed it on the $2 trillion issue. “I used to run the sovereign ratings group at S&P and would not necessarily have used such projections in the rating analysis/rationale as the main point is that US has no plan to cut the deficit long term, not that debt will be $2 trillion lower or higher,” Kotecha says
• It is debatable whether S&P is right or Moody’s and Fitch are right on the US rating.

Joshua Feldstein, a market data analyst, thinks the downgrade will adversely affect the US credit market. “Although the downgrade is unprecedented for US securities, these securities still represent the safest haven amidst uncertainties in the European markets, with the European Central Bank printing additional money to cover the debts for Italy and Spain in the near term,” he says. “Theoretically, the Federal Reserve could do the same. The difficulty is not whether we would default, but that buyers of our debt would be paid back with depreciated dollars. S&P put themselves in a box, having announced that the grand bargain in the debt ceiling deal had to be $4 trillion. When the deal fell well short of that figure, they had no choice but to downgrade or suffer the indignity of losing further credibility than they already from their errors in rating structured products that led the financial debacle in 2008.”

Chris Toney, a money market manager, reports that prior to the S&P downgrade there were articles on the major news outlets such as Reuters, Bloomberg, and the Wall Street Journal says that the Bank of New York was telling large clients that it would be charging them a fee to hold their cash. “This was in conjunction with the Dow drop of about 500 points and around the time that the one month Treasury bill during intra-day trading fell into negative territory,” he says. “It was the first time in a few months that people were willing to pay or take zero returns just to leave it in a place and not invest it.”

Toney says that actions like this speak a great deal to what banks and investors fear these days. “The bottom line is that banks are a business. They are meant to churn out profits. The good news is that banks are showing strength in that they can walk away from this type of financing, as unstable or less sticky as it might seem,” he says. “The really bad news is that this type of action is indicative of current liquidity fears and the dangers of a painfully low rate environment.” He points out that S&P’s assessment and eventual downgrade, rightly or wrongly, is its opinion. “It is S&P’s analysis. If one believes the rating is flawed, that calls into question the value of S&P as a research source.”

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Experts comment on recent US downgrade in credit markets: Part 2

By Maureen Aylward

We asked our Zintro experts to comment on the recent S&P downgrade and its impact on the debt markets and other global markets. Clearly the markets are still reeling and shaking. Here is the second in a three part series on the issue as seen from a multitude of perspectives.

Kinuthia Karanja, a financial services expert, says that the S&P downgrade was ill advised and seems to have had ulterior motives. “The credit agency acted after the vote in Congress, not before. Nevertheless, on a timing basis, it provided a turning point in global stock markets and will surely cause concern amongst both Democrats and Republicans,” he says. “Main Street plunged into the chasm of economic depression after the real estate crash of 2007. And the Debt Crisis is an additional nail in the coffin, just as it was in 1931 when the European and South American Debt Crises cemented the depression. Great Britain defaulted on its foreign obligations in 1931. Could the United States be headed for the same fate by 2016?”

Al Rio, a risk analyst consultant, says that the extreme volatility in the markets is forcing many investors (individuals and corporations) to park their money in idling accounts that yield little benefit. See BNY Mellon, which last week announced that some depositors above $50 million will be charged for keeping the money there,” he says.

“It will take a time to clearly see the effects (months, maybe a year) on consumers. Changes in monetary policy (e.g., new rounds of so-called quantitative easing due to concerns of slowdown) can increase inflation. With positive inflation surprises come redistribution of wealth from lenders to borrowers; negative inflation surprises do the opposite. Such redistributions will increase bankruptcies, which means some providers will not get paid and some financial institutions will see loan quality worsen.”

Rich Bialek, a strategy consultant, says that the US downgrade is a reality check for the US and global economies. “It is a case where perception is reality. S&P’s perception of a weaker US economy is correct given the ratio of US government debt to equity, ineffective fiscal policy, slow to no growth, high unemployment, and even higher underemployment. In the immediate term, stocks will continue to fall in the US and other global equity markets,” he says. “The downgrade is not likely to increase interest rates for Main Street. Although our economic house is in need of repair, it is still the best house in a global neighborhood that has suffered. If the US economy of today is rated AA+, it is still stronger than any other economy. The downgrade is not relative to other current economies, but only to the US of five years ago.”

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Experts comment on recent US downgrade: Part 1

By Maureen Aylward

We asked our Zintro experts to comment on the recent S&P downgrade and its impact on the global markets. Clearly the markets are still reeling and shaking. Here is the first in a three part series on the issue as seen from a multitude of perspectives.

Donald Cummings, a fixed interest investment manager, address specific fallout in the bond holdings area as it pertains to portfolio management: “First, this downgrade was minimal, a shot across the bow. Not only have US Treasuries been downgraded, but there are some municipal bonds (pre-refunded and escrowed municipal bonds for example) that will get downgraded too because they rely on US Treasuries for payment of principal and interest,” explains Cummings. “For portfolio managers that keep a certain percentage of a fixed income portfolio in AAA, a percentage in AA, a percentage in A, this will cause portfolio trading and reallocating.”

Cummings says that if the downgrade had placed US Treasuries into a non-investment grade category there would be widespread disruptions in the market. “Banks need to have a certain percentage of their portfolios in riskless assets, and if US Treasuries lost that category place they might have to be sold. Banks are not able to take on additional risk assets like loans until their ratios go back up to legal requirements,” he says.

On the trust side, Cummings says that there are millions of trust accounts managed for people and the fiduciary (a bank trust department or other money manager) most likely has a fiduciary duty to investment grade securities. “If US Treasuries had fallen to non-investment grade, potentially every trust officer in the country would have to sell Treasuries and move assets into something more riskless. The same goes for pension funds, which are subject to strict laws about investment categories,” explains Cummings

Nashish, an expert in fund management, thinks that the impact of US credit rating downgrade is going to be huge for the markets. “It will have both positive and negative impact, but what we need to look at is the downgrade coupled with the European crisis, so the impact will be more far reaching,” he predicts. “First looking at the negatives, the world economy will head for further slowdown, especially in developed economies. This will affect corporate earnings and lead to equities markets turning volatile.  Commodities prices will also tank, so it will have some positive impact especially for emerging markets that are desperately fighting inflation.”

Nashish says we will see the strengthening of emerging economies as they become the drivers of global economic growth. “There could be liquidity issues in the capital markets, but I do not expect the central banks globally to act in a coordinated fashion like they did in 2008 to pump in liquidity.

On the positive side, Nashish says the fixed income market will see an economic slowdown, but lower inflation. “You can expect bonds to rally, equity markets to remain volatile, and commodity prices to correct further,” he says

Ankit Arora, a financial markets consultant, thinks the S&P downgrade of US bonds from AAA to AA+ will have a short- to medium-term impact on the world economy.

“An example is the IT industry. For example, with the downgrade the US may get less fund flow, and organizations may find it difficult to raise money. This will impact the capacity to implement IT solutions and lead to a reduction in IT spending, hurting IT vendors across the globe,” he says. “Investors will now move to a safe haven like gold and other metals. The prices of these commodities will definitely rise as more investment flows in these asset classes.”

Arora says there is cause for concern in economies that are heavily dependent on US for exports. For example, Japan exports around 16 percent of its total exports to US. Taiwan exports around 10 percent of its total exports to US. These export driven economies that have high dependency on the US will need to reduce exposure by diversifying exports and by making domestic consumption better.

“China, followed by Japan, is the highest holder of US treasury securities, which means that these countries will have a huge concern over the downgrade of treasury. In the long run, I feel that the BRIC nations will be less affected compared to other economies,” says Arora. “There is definitely impact on shares of Indian corporations, but this offers an opportunity to buy blue chip stocks at throw-away prices. One should look for investment in those companies that have strong fundamentals and whose stocks are available at low prices.”

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How will the rise in China’s interest rates effect US debt?

While rising inflation causes China and the rest of the world to remain concerned over its political, social, and economic stability, the US continues to fear its own growing mountain of debt and the risk of inflation. We turned to one of our fixed income experts and asked him to share his opinion on the link between the increased interest rates in China and the large deficit in the US. Here’s what he had to say:

Michael Romanovsky, a consultant on a wide range of business and organization-related matters in areas of economic analysis, business and marketing strategy, game design, and general project management, says that the effect of the recent Chinese interest rate change on US government debt is “three-fold.” All other significant factors staying constant, an interest rate hike curtails domestic spending in China, which can cause the trade deficit to increase. This subsequently increases US government deficit and debt “because of lower taxes generated from manufacturers.” Second, Romanovsky explains that an interest hike indicates that the US government will need to raise its own interest rate in order to attract buyers to the US federal bonds market, or “risk being unable to borrow significant funds.” The raise in interest rates greatly impacts any significant economic recovery in the US, because increased interest rates make it more difficult for business to borrow money to expand. Unfortunately, this leads to higher taxes and causes “the deficit to further decrease.”

Romanovsky adds that the changes and restructuring in the world economy, like the slow recovery of the US in the recent recession as well as the immense unemployment and changes of government in North African and Middle Eastern countries, greatly affects US debt. Contributing factors like “lower supply and higher demand of basic necessities” within unstable and vulnerable developing countries dampen economic growth throughout the world. Romanovsky references the projected increase in the cost of ocean shipping, which will have a substantial impact on US-China trade. In order for trade to become balanced and maintain economic stability, Romanovsky recommends a “re-alignment from high deficit spending to much lower deficit spending in the US” from both the private and public sector. Moreover, a re-evaluation of the yuan to decrease China’s trade deficit and manage increased Chinese consumption will cause the dollar to weaken, which means US debt will “effectively be lower” and US unemployment will be decreased due to “exportable product-based jobs.” However, this also means that US consumers will find many goods more expensive than before. Romanovsky recognizes that both countries have struggled to keep up with the shift in a relationship from “one of cheap goods in exchange for technology to one of all kinds of goods and services in exchange for all kinds of other goods and services.” Ultimately, the path to a more balanced trade between US and China is “riddled with potential price shocks” that the government must try, and prevent and individuals “must carefully monitor.”

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