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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