U.S. Debt Rating Downgraded

After the market close on Friday, Standard and Poor’s (S&P)—one of the three major U.S. rating agencies—downgraded the U.S. government debt from AAA to AA+. This is actually a drop of less than one level within the S&P rating system. According to S&P, an obligor rated AAA has "extremely strong capacity to meet its financial commitments" while one of AA has "very strong capacity to meet its financial commitments" and differs from AAA obligors "only to a small degree." Therefore, U.S. debt is still rated very strong. In addition, the two other major U.S. rating agencies, Moody’s and Fitch, have maintained their highest ratings for U.S. federal debt. S&P kept the short-term rating of the United States at the top rating of A1+. Short-term money market instruments are rated on a different scale, but the status quo with respect to these ratings implies no impact to money market funds.

Since the first U.S. rating agency was established in the early 1900s, the U.S. government has not been downgraded. Frankly, a downgrade just sounds and feels bad. The word "downgrade" has similar negative connotations to words like "demotion" or "decline." However, while this is the first time that the United States has been downgraded by a U.S. rating agency, it is not the first time that the United States has been downgraded. The United States was downgraded one level by China’s Dagong Global Credit Rating Company to A+ in November 2010 and by Germany’s Feri Rating Agency to AA in June 2011.

There is also much precedent for other AAA-rated sovereign nations seeing their debt downgraded. Japan lost its AAA rating in 1998 and Canada was downgraded in 1994—however, both successfully regained their AAA status at later dates. Japan lost its AAA status again in 2009. Though this downgrade feels unique and unprecedented, it has already happened relatively recently to the United States without much attention and to other sovereign nations in the past.

As investors, we need to take this downgrade as what it is—a change in status that does not meaningfully diminish the term "full faith and credit of the U.S. government." In fact, the debt of the United States continues to be viewed as preeminently high quality. One measure of this is to examine the credit default swap market, which is similar to insurance that institutional investors can buy to protect their bonds in case of default. Even after the downgrade by S&P, the cost to "insure" against the default of the U.S. government is much lower than nearly every country in the world, including many AAA credits like Germany, France, and the United Kingdom. Therefore, even though U.S. debt does not still carry a full AAA rating, the market still views the U.S. government’s ability to meet its debt obligations as AAA worthy.

So, what does this all mean to the markets? S&P telegraphed their downgrade starting a couple of weeks ago while the debt ceiling debate was still ongoing. As a result, I believe that the markets have largely priced this downgrade news in. In addition, we have likely not seen the last of downgrades. Now that the United States has been downgraded, S&P will separately be reviewing government agencies and companies that rely heavily on U.S. government support—such as Fannie Mae, Ginnie Mae, and Freddie Mac—for potential changes in credit rating. That said, further downward price moves in the stock market are likely not attributable to the downgrade of U.S. debt, but rather escalating concerns around the European crisis and decelerating global economic growth. In a sense, the downgrade of U.S. debt is not nearly as important to the market as is the potential downshift in the strength of the global economic recovery.

While we have to acknowledge that the risks for a double-dip recession have been creeping up as of late, I continue to believe that it is extremely unlikely. The market appears to be pricing in a far greater likelihood for a return to recession than the data actually indicates. As a result, stock valuations are cheap versus historical averages. The S&P 500 Index trailing price-to-earnings (P/E) ratio, a measure of how much the market values a dollar’s worth of corporate earnings, is at 13 (the lowest since 1990) and the forward P/E ratio is 11 (same as March 2009 low).Essentially, the market is as cheap, or even cheaper, now than it was during the depths of the 2008-2009 recession.

The visceral, emotional reactions to this downgrade are normal, but I believe that the S&P rating downgrade is more disappointing than it is material for capital markets. While the market may react emotionally to the news over the short run, rational analysis will soon reveal that continued favorable economic fundamentals and attractive valuations point to potentially promising investment opportunities just around the corner. I believe that maintaining a cautious stance remains prudent, but systematic additions to risk at these levels will prove a wise investment as the year unfolds. As always, if you have questions, I encourage you to contact me.　

Best regards, Mark C. Gosselin

Mark C. Gosselin
Branch Manager
Investment Consultant
11200 Broadway
Suite 2743
Pearland, TX 77584
832 895 6627 office

www.markgosselin.com

LPL Financial, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing.

All performance referenced is historical and is no guarantee of future results.

All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong.

The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

Credit rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities.

Stock investing may involve risk including loss of principal.

This research material has been prepared by LPL Financial.

Tracking #786254 | (Exp.08/12)

　
　

Debt Ceiling Raised

The hard fought debate in Washington has come to an end. A two-step deal to lift the debt ceiling by $2.1 trillion and cut about $2.4 trillion in spending over a decade has been signed into law. The increase to the debt ceiling has lifted some of the uncertainty that has weighed on investors, businesses, and consumers, who were unsettled by talk about a possible new and deep financial crisis.

Still, the deal does not go far enough to put the United States on a path of fiscal sustainability, with deficits projected to continue to rise, nor does it decisively remove the threat of a downgrade to the nation's AAA credit rating. The size of the spending cuts will have minimal impact on the economy in the near term as they will be phased in slowly with little effect until 2013, after the next election.

While investors may be relieved by the agreement to raise the debt ceiling and avoid default, the market is likely to continue to be held captive by Washington for the rest of 2011. The budget agreement that averted a government shutdown earlier this year, and provided a preview of the current battle in Washington, only funded the government for the 2011 fiscal year which ends September 30, 2011. While the current deal making in Washington may alleviate the problem of “running out of debt capacity”, the government will soon “run out of money” if another deal is not reached by the end of next month to avoid a shutdown. And, this will be exacerbated by the vote by Congress over the $1.5 trillion second round of spending cuts and boost to the debt ceiling, which is set for December 23. These two events combined will mean another market-volatility inducing budget and debt battle is on tap for early this fall.

While raising the debt ceiling was an important hurdle to clear, the latest battle over the national debt reflects only a small portion of the nation's total liabilities. The biggest budgetary expenses are Medicare, Medicaid, and Social Security, which account for nearly half of all spending and seven times what is spent on servicing the nation’s debt. Until these items are addressed through politically polarizing entitlement cuts and/or revenue increases, the nation is still not on a path to fiscal sustainability, resulting in the markets having to deal with continued fiscal fights for the foreseeable future.

In the near term, investors may refocus their attention on the economy. While economic growth may remain below average and data may be volatile, any signs of improvement could inspire investors to re-engage the markets and reduce defensive positions now that the debt ceiling concerns are lifting. One outcome is clear, volatility is here to stay. As always, if you have questions, I encourage you to contact me.

Sincerely, Mark C. Gosselin 
 

Mark C. Gosselin
Branch Manager
Investment Consultant
11200 Broadway
Suite 2743
Pearland, TX 77584
832 895 6627 office
http://www.markgosselin.com 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing.

All performance referenced is historical and is no guarantee of future results.

All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong.

Credit rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities.

This research material has been prepared by LPL Financial.

Tracking #750682 | (Exp.08/12)