Investors deem US downgrade 'humiliating', but not a game changer

August 8, 2011 :: Intelligence on European Pensions and Institutional Investment

Read the article online here.

GLOBAL – Investors appeared split over the significance of the downgrading of US debt by Standard & Poor’s, with some deeming it “humiliating” and arguing it risked undermining the world currency, while Legg Mason branded it “wrong and dangerous”.

The reactions came as the price of Treasury bonds rose, despite the ratings agency downgrading the country to AA+ in the wake of US Congress last week negotiating a new debt ceiling as it approached its $14.3trn (€10.1trn) limit.

Commentators were divided on the wisdom behind the decision, with Barings Asset Management viewing the country’s continued AAA rating as unsustainable, according to the company’s head of fixed income and currency Alan Wilde.

Wilde said that, in the medium term, the most important unknown was the reaction from overseas public sector money to the downgrade.

“The extent to which foreign central banks and sovereign wealth funds buy US Treasuries to benefit from the security of a US government promise is unknown,” he said.

Dominic Rossi, global chief investment officer for equities at Fidelity International, highlighted concerns by S&P that the current political climate in the US had triggered the downgrade, rather than the country’s growing debt.

He said the downgrade risked undermining the world reserve currency and raised the prospect of stagflation in the US, adding: “It is humiliating for the government, and it is an indictment of the federal system.”

In its note explaining the downgrade, S&P said the “effectiveness, stability and predictability” of US policy had been weakened at a time of economic challenges, following weeks of stalled negotiations between the Republican and Democratic parties.

US pension funds representing more than $1trn of assets and led by CalPERS had earlier warned about the “very real and serious” impact of a downgrade if the US government failed to address its growing deficit.

BlackRock, the world’s largest asset manager, argued that the downgrade reflected facts that had been known to the market “for some time”, insisting that it therefore did not mean a fundamental increase in risk for investors.

However, it said that, coupled with continued economic instability, some investors would be advised to reassess their risk appetite – despite admitting that there were “few genuine alternatives” to those who opted out of the US bond market.

It seemed to echo S&P’s assessment that the downgrade was prompted by political instability, saying: “The US economy has historically been the world’s most resilient, but its future depends on policymakers coming together to make the hard decisions needed to arrest the growth of the US public deficit.

“There is time to address these challenges, but if policymakers fail to do so, this weekend’s credit downgrade will be a sign of continued fiscal deterioration.”

However, Bill Miller, chairman of Legg Mason Capital Management, branded the ratings agency’s decision to announce the downgrade following a week-long fall in equity markets and uncertainty surrounding the European bond markets as “wrong and dangerous”.

“At best, S&P showed a stunning ignorance and complete disregard for the potential consequences of its actions on a fragile global financial system,” he insisted.

Miller went on to attack ratings agencies as a whole, saying it was “totally unacceptable” that private companies run for profit functioned as quasi-regulatory authorities.

“The disastrously flawed ratings of these agencies were at the heart of the financial crisis of 2008,” he said, arguing that the unilateral action taken by S&P risked creating further mayhem.

The impact of the downgrade on capital requirements for the financial sector was also raised, with Erik Ristuben, chief investment officer of client investment strategies at Russell Investments, saying the issue raised “technical concerns”.

However, Andreas Utermann, chief investment officer at Allianz Global Investors subsidiary RCM, speculated that a change in regulation might follow, with the lack of an alternative to the Treasury bonds meaning investment guidelines would be adapted to accommodate the downgrade.

He warned that the focus would now shift to the AAA ratings of European countries, such as France.

“On the basis of decisions reached at the EU Summit in July, the European Financial Stability Facility should assume its duties as soon as possible,” he said. “The market situation will aid a speedy transition to a transfer union within the euro-zone.”

Author: Jim Robinson


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