Key Points:

• On 5 August 2011, S&P downgraded the US sovereign credit rating one notch, from AAA to AA+
• This was the first downgrade since US debt was rated AAA in 1917
• Bond market reaction counterintuitive, with Treasury yields declining further; indicative of the lack of alternative risk-free assets at present
• Equities have reacted adversely, as a demonstration of heightened risk aversion
• We continue to view S&P’s downgrade as symbolic rather than having any real economic implications
• The “flight-to-safety” phenomenon appears to be a case of investor overreaction, and investors may wish to take advantage of the low stock market valuations to increase equity exposure, especially in the case of GEM equities

What has happened?

On 5 August 2011, Standard and Poor’s (S&P) downgraded the US sovereign credit rating by one notch to AA+, down from AAA, marking the first time the US has lost its AAA status since it first attained this top rating in 1917. Moody’s and Fitch ratings (which make up the other two members of the “big-three” credit rating agencies) have both left the US sovereign credit rating unchanged, but have warned that additional deficit-reduction measures will be required to ensure that the US’ credit rating will not be cut in the near future.

In our view, the downgrade by S&P merely reflects what the ratings agency perceives as insufficient measures taken to tackle the US deficit, and since outstanding US debt is denominated in US dollars which the government has the ability to print, we continue to see little risk that the US government will actually default on its debt.

How have financial assets reacted?

In an earlier article, we suggested that a downgrade would be more symbolic in nature, rather than reflect any actual increase in default risk. Nevertheless, we suggested that US bond yields should rise (given the higher implicit default risk of a lower-rated security) in response to a downgrade, while the US dollar would be expected to be more volatile (but not necessarily lower in the near term). Also, we highlighted that heightened risk aversion could result, if there were concerns that higher yields on the global risk-free asset would result in higher borrowing costs for the corporate sector.

Following S&P’s downgrade, the bond market reaction has been counterintuitive, with US Treasury yields sliding further (resulting in higher bond prices). The US dollar reaction has generally been muted, with the Dollar Index slipping 0.6% (as of 8 August 2011) since S&P’s announcement. While the bond market and US dollar have seemingly not reacted adversely to the news, risky assets have seen a huge negative reaction, with Asian equity markets down substantially on 8 August 2011 in a display of heightened investor risk aversion. Initial investor reaction clearly highlights a “flight-to-safety” mentality, with US Treasuries still maintaining their status as the preferred risk-free asset.

Our Take

As with our earlier comments on a potential US credit rating downgrade, we continue to see no viable alternative to US dollar as the world’s reserve currency (at least in the near term), which means that investors will continue to buy US Treasuries (and view them as risk-free), even with the latest rating downgrade. While implicit links between some municipal issues or quasi-sovereign entities and the US Federal government could result in further downgrades of credit ratings for various state-linked entities, we do not expect these anticipated downgrades to choke their access to funding, and the “contagion” from the public sector to the private sector in terms of higher borrowing costs should not materialise. Also, given that the downgrade is largely symbolic in nature, we do not see the latest move by S&P as having any direct impact on global economic growth.

How should investors react?

Equities

The “flight-to-safety” phenomenon following S&P’s downgrade suggests a case of investor overreaction, with investors choosing to dump assets perceived as riskier (like equities). Even as investor sentiment remains poor on continued concerns over slowing US economic growth and the Euro-zone sovereign debt crisis, we see the latest bout of market weakness as an opportunity for investors to take positions in equity funds, given that valuations have fallen to compelling levels as markets have corrected in recent weeks.

Global emerging market like India are highly sensitive to global investor flows and have been negatively impacted in the latest bout of market volatility, but are also furthest removed from the current issues at hand (US economic growth concerns, Euro-zone debt issues). Investors may thus wish to increase exposure to Indian Equity funds via our recommended equity funds.