What Does the S&P Decision on U.S. Credit Mean for Investors?

Yesterday, Standard and Poor’s revised their outlook on the long term rating of U.S. AAA credit to “Negative”, with a one-in-three chance for the likelihood of lowing the rating.

The opinion was issued with a statement that indicated their concern with the uncertainty surrounding the large budget deficits and rising government indebtedness.

With debt-to-GDP at 80%, there is concern for the US to handle any additional shocks to the financial system.  This news caused stocks to drop over 1.5% on the day while the dollar strengthened and US Treasuries remained stable. So what does this really mean?

A downgrade in the credit rating of any company or country usually leads to higher borrowing costs for that entity.  That translates into higher interest rates as investors demand higher yields to compensate for the increase in perceived risk. At the very least, the perceived risk of losing money by owning U.S. treasuries appears to be higher.

Significantly higher interest rates could lead to a reduction in economic growth along with higher inflation.

All eyes will be on policy maker’s ability to address budgetary issues and provide a viable solution over the coming year to avoid an actual downgrade.  Arguably, it is a topic that has been weighing on the US and contributing to the weakness of the Dollar.

Even if US debt is downgraded, it’s not likely that a downgrade would mean the U.S. would default on its debt.  The Federal Reserve has the ability to print money in order to repay its debt.  While this would contribute to higher inflation, it would not lead to default.

The move does not affect our outlook for the stock or bond markets.

We continue to be positioned for rising rates and a stock market that moves only slightly higher for the year.  The bottom line is that while bonds remain an important part of a well-rounded portfolio, it makes sense to lower exposure to U.S. treasuries and diversify into other yield-producing investments less correlated with the treasury market.