A blunt warning from Standard & Poor’s that the U.S. is at serious risk of losing its Aaa credit rating seemed to turn the financial markets upside down. Bond prices actually rose on the news, gaining 9/32 of a point and pushing yield down to 3.373 percent. Stock prices fell. For fixed income strategists such as Georg Schuh, the chief investment officer of DB Advisors Europe, it was a sign that rising pressure will force the White House and Congressional lawmakers to come to terms with the growing U.S. fiscal burden. “Global investors will impose fiscal discipline on the U.S.,” Schuh says. DB Advisors is the institutional asset management arm of Deutsche Bank.
While bond investors seemed to view the S&P report as a form of tough love, equity investors were less sanguine. The Standard & Poor’s 500 fell 1.10 percent on the news, its biggest decline in a month. Stocks recovered only some of that loss on Tuesday.
The reaction shows that equity investors have plenty to fear if the U.S. can’t get its fiscal policy in order. If the government loses its Aaa crediting rating, government borrowing costs will rise. And since those rates are benchmarks for corporate credit, companies will pay more to access the credit markets, too. Higher borrowing costs will eat into the cash flow of U.S. corporations, putting pressure on earnings.
“If the sovereign debt rating drops, all corporate debt ratings will take a massive hit,” says Phil Phan, an executive dean at the Cary Business School at Johns Hopkins.
Equity investors also have reason to be unsettled by the prospect of higher inflation. While inflation doesn’t necessarily threaten equity values in the way that it threatens fixed income, it can be a problem.
That’s because equity investors will attach a lower multiple to earnings growth that is driven by inflation, as opposed to actual business gains and pricing power.
The U.S. has only a limited number of options as it seeks to address its growing fiscal problems. It can attack the problem head on with a program or spending cuts or tax increases. Failing that solution, it can inflate its way out of the problem, which could lower the quality of corporate earnings growth.
And as S&P notes, there’s a significant chance the U.S. will take the path of least resistance, failing to cut spending or boost taxes in a significant way.
“We see the path to agreement as challenging because the gap between the parties remains wide. We believe there is a significant risk that Congressional negotiations could result in no agreement on a medium-term fiscal strategy until after the fall 2012... If so, the first budget proposal that could include related measures would be Budget 2014 ... and we believe a delay beyond that time is possible,” S&P analyst Nikola G. Swann warned in his report.
The last few years of emergency economic policy have been good for stock prices. The Standard & Poor’s 500 has roughly doubled to 1305.14 since its financial-crisis low in March 2009. But now equity investors seem to fear that an unending future of massive government spending, super low interest rates and asset purchases may be too much of a good thing.
