In an unprecedented move this weekend, Standard & Poor's downgraded the United States Debt rating to AA+ from AAA. They also placed the U. S. Government on negative watch and downgraded some of the debt ratings on certain government agencies. They maintained the AAA rating on short-term obligations. Following the downgrade, Moodys and Fitch both re-affirmed their AAA ratings on U.S. debt. In an unusual admission, S&P indicated their original evaluation over-stated the U.S. obligations by over two trillion dollars, but the correction did not change their analysis.
This news fed on fears already surfacing about a slowing world economy, Washington politics, European Sovereign debt issues and slowing emerging economies.
So what do these events mean?
Last year, the stock market declined 17% between late April and July, but government intervention and an economy that continued to grow, rather than slide into a recession, fed a robust recovery. As of this morning, we are down about 15% from the April 29th high.
In many ways, the downgrade seems to be a political commentary. An outright default is highly unlikely since all of the debt of the United States is in US dollars and the United States prints its own currency. S&P ratings are supposed to focus on the risk of default, not the risk of inflation. Further, many countries, such as France, do not print their own currencies, have more debt as a percent of GDP, yet retain their AAA rating. With these points in mind, the S&P downgrade is rather curious. Indeed, we note that Treasuries are trading up today in a flight to quality, underscoring that investors are not concerned about Treasury default. Further, seven to ten year Treasuries are up almost 6% in the last month and corporate bonds have followed suit.
How is this different from 2008?
The U.S. economy was in a recession for over six months when the financial crisis hit in the fall of 2008. Earnings were falling, while now they look to be up almost ten percent in the latest earnings season. Banks and governments were slow to react in 2008 and were in basic denial as to the severity of their problems. The banks had substantial unrecognized off-balance sheet liabilities and were severely under-capitalized while now, capital ratios are at the highest levels in forty years and balance sheets are much cleaner.
Is the market over-valued?
It all depends on whether we are falling into a recession, the odds of which are higher than even three months ago. Most experts still put the odds at less than fifty percent with the second half of this year benefitting from Japan, the world's second largest economy, coming back on line from their tragic calamity. Stock market valuation levels are certainly closer to their historical lows than to their historical highs. Therefore, we believe this market correction is more like last year's than 2008.