Stocks Plummet on Downgrade, as Obama Defends AAA; Market Gurus El-Erian, Rogers Weigh In

Market strategists analyze downgrade, as Obama says spending cuts must be combined with tax reform and adjustments to other programs

Traders work on the floor of the New York Stock Exchange on Monday. (AP Photo/Jin Lee) Traders work on the floor of the New York Stock Exchange on Monday. (AP Photo/Jin Lee)

While markets around the world and in the U.S. plummeted Monday after Friday’s news that Standard & Poor’s downgraded U.S. debt one notch to AA+, President Barack Obama said Monday afternoon that U.S. credit was “among the best in the world,” and that the real focus should be on tackling the nation’s deficit over the long term.

“No matter what some agency says, we always have been, and always will be, a triple-A-rated country,” Obama said from the White House.

The downgrade from S&P was given “not so much because [S&P] doubts our ability to pay our debt if we make good decisions, but because after witnessing over a month of wrangling over raising the debt ceiling, they doubted our political system’s ability to act,” Obama said. “The markets continue to believe our credit status is triple-A.” Obama cited comments from Warren Buffett about the downgrade, in which Buffett said that “If there were a quadruple-A rating, I’d give the United States that.”

The solution to reducing the nation’s deficit, Obama said, is combining spending cuts with “tax reform and modest adjustments to healthcare programs like Medicare.” Friday’s downgrade news from S&P, he went on to say, will give the nation “a renewed sense of urgency,” to reduce the deficit. However, he said the current environment in Washington of refusing “to put what’s best for the country ahead of self-interest and ideaology must change.” 

At the close on Monday, the Dow Jones industrial average dove 634.76 points, or 5.55%, to 10,809.85. The S&P 500 Index slid 79.92 points, or 6.66%, to 1,119.46. The Nasdaq Composite Index tumbled 174.72 points, or 6.90%, to 2,357.69.

European markets also closed sharply, with Germany's DAX leading the selloff, falling 5.02%.

However, on news of the downgrade, gold surged to a bit more than $1,700 per ounce as investors fled equities.

The two other ratings agencies—Moody’s Investors Service and Fitch—have yet to downgrade U.S. debt. Moody’s announced July 13 that it had placed the U.S.’ debt rating on “review” for a possible downgrade, but in early August the ratings agency stated that the “initial increase of the debt limit by $900 billion and the commitment to raise it by a further $1.2-1.5 trillion by year-end have virtually eliminated the risk of such a default, prompting the confirmation of the [U.S.] rating at Aaa.”

Fitch Ratings noted in a statement on its website that as expected, “agreement was reached on an increase in the United States’ debt ceiling and, commensurate with its ‘AAA’ rating, the risk of sovereign default remains extremely low.” While the debt ceiling agreement is clearly a step in the right direction, Fitch continued, “The United States, as in much of Europe, must also confront tough choices on tax and spending against a weak economic back drop if the budget deficit and government debt is to be cut to safer levels over the medium term.”

Market strategists were quick to weigh in with their comments about the downgrade.

Mohamed El-Erian, PIMCO

mohamed el-erianThe “terms risk free” and “U.S. Treasuries” were once interchangeable; no longer, PIMCO CEO Mohamed El-Erian said Saturday after news of S&P’s downgrade.

“For the real economy, credit costs for virtually all American borrowers will be higher over time than they would have been otherwise,” El-Erian wrote in an op-ed for The Financial Times. “Animal spirits, already hobbled by the debt ceiling debacle, will again be dampened, constituting yet another headwind to the generation of investment and employment.”

El-Erian notes that a domino effect will likely occur as a result of Friday’s action, and downgrades of European countries, in particular, will ensue.

“It is hard to imagine that, having downgraded the US, S&P will not follow suit on at least one of the other members of the dwindling club of sovereign AAAs. If this were to materialize and involve a country like France, for example, it could complicate the already fragile efforts by Europe to rescue countries in its periphery.”

Rating agencies have come under intense scrutiny and criticism for their role in failing to accurately evaluate mortgage-related investments leading to economic collapse in 2008. The bold step S&P has now taken will only increase said scrutiny, El-Erian says.

“S&P’s action will likely unite governments in America and Europe in an effort to erode their monopoly power and operational influence. This will also force all investors to do something that they should have been doing for years: conduct their own ratings due diligence, rather than rely on outsiders.”

But more worrisome, he writes that “there will now be genuine uncertainties as to wider systemic impact of this change …This will weaken the effectiveness of the U.S. as the global anchor, accelerating the unsteady migration to a multi-polar system while increasing the risk of economic fragmentation.”

As bad as it sounds El-Erian points to a silver lining, noting the downgrade “may serve as a wakeup call for its policymakers. It is an unambiguous and loud signal of the country’s eroding economic strength and global standing. It renders urgent the need to regain the initiative through better economic policymaking and more coherent governance.”

David Kelly, chief market strategist, J.P. Morgan Funds

david kellyDavid Kelly, chief market strategist for J.P. Morgan Funds, says in his "Notes on the Week Ahead" commentary released Monday that investors should be focused on four issues this week:

 

  • The fallout from S&P’s downgrade of U.S. sovereign debt.
  • The potential for more turmoil emanating from Europe’s debt crisis.
  • Any clues on whether the economy is strengthening or weakening in the third quarter, and,
  • What, if anything, the Federal Reserve may want to do about all of this at their August 9th meeting.

Kelly said that media coverage of the downgrade “has emphasized its potential to boost not only Treasury yields but also interest rates paid by consumers and businesses across the economy. “

However, in theory, he continued, “the downgrade effect should show up immediately since all market participants are now fully aware of it and the extremely low levels of interest rates while the market operated under the threat of a downgrade doesn’t suggest a surge in rates in reaction to it. In time, less market volatility and better economic growth should push interest rates much higher. But if this occurs, it won’t be because of the downgrade.”

On the positive side, Kelly went on to say, “this in an economy characterized by significant pent-up demand, very low interest rates, good growth in exports and much improved consumer and corporate balance sheets.” With a spark of confidence, he continued, “growth could easily accelerate, even with no further aid from fiscal or monetary policy.

On the negative side, however, “the turmoil in markets has left the economy with a significant confidence deficit, and this will not have been helped by S&P’s actions of late last week.”

For investors, while the “threat of an economic slowdown is quite real,” Kelly said, “balanced against this has to be the fact that falling interest rates, falling stock prices and surging earnings have left stocks looking extremely cheap relative to bonds and cash. The stock and bond markets have already apparently priced in very significant weakness and volatility.”

Concluded Kelly: “On one side, then, are fears of fear. On the other are compelling valuations. For investors, hard as it is to do nothing at a time when events seem to outpace analysis, the best advice probably remains to be balanced and to stay balanced.”

Axel Merk, Merk Funds

axel merkThere’s no silver lining to S&P’s downgrade of U.S. debt, Axel Merk, portfolio manager of Merk Funds, said in a statement following the announcement.

“The downgrade of U.S. government debt by S&P is the result of policies pursued over many years that rely on the U.S. being the world's reserve currency,” he said. “Policy makers have forgotten that the status must be earned; it's not a birthright.”

Merk warns that the downgrade could be taken lightly by some investors. “Ratings agencies don’t want to be caught late in downgrading anyone these days,” he said. “As such, many may initially shrug off the downgrade.” The downgrade could precede deleveraging, according to Merk, if U.S. regulators require more collateral.

Initially, the bond market may experience rebalancing to increase average security quality, but as a result, could increase allocations to Treasury securities, Merk said.

Long-term damage in the bond market could be severe, he added, but warned that “like a frog in a boiling pot,” pundits will probably ignore that possibility when facing a less severe initial bond market reaction.

Merk is reducing currency allocations in Canadian, Australian and New Zealand dollars, and reallocating to the euro, Norwegian krone and Japanese yen. “We did not foresee the timing of the downgrade, but positioned ourselves for further global de-leveraging and long-term dollar weakness,” he said. “The downgrade is a symptom, not a trigger, of the environment we are in.”

The only beneficiary of the downgrade, Merk said, is corporates, as the market appears to have embraced some corporations as more creditworthy than the government.

Jim Rogers, chairman of Rogers Holdings

jim rogersIn an online interview with the “Economic Times” of India, Jim Rogers, chairman of Rogers Holdings (and a co-founder of the Quantum Fund with George Soros) described his views on the U.S. downgrade as well as commodities and when to buy them.

“This is not news,” Rogers said. “Everybody in the world knows that America is not a AAA rating; everybody in the world knows America is the largest debtor nation in the history of the world and is getting [worse]. That is not what is causing the markets to go down. The markets are going down for many reasons.” 

As for Rogers’ current investing themes, he said if he were to buy something in the short term, it would be agricultural commodities. “I would not be buying stocks. Stocks are going to be, at best, in a trading range for years to come,” he explained. When it comes to gold and silver, Rogers insists he will look to buy “more” when it starts to go down. He insists that a bubble is coming, but not in the short term.

“When everybody is buying commodities and everybody owns them, they would be getting close to a bubble, [and] we would have a bubble,” he explained. “But that is a few years away, probably several years away.” 

The current market climate, the Singapore-based investment expert says, is like that of the ‘70s. “Well, anything can happen, but in the 1970s stocks did nothing, they were like this or went down in the 1970s for 10 or 14 years, but commodities went through the roof,” he shared. “In commodities we are in those kinds of days again. Commodities are going to be in a bull market. Stocks are going to be problematically at best.”

He also cautions investors against “safe haven” thinking. “There is no such thing as a safe haven investment. I wish they were. Gold went down something like 70% from its top during the 1980s and 1990s, even silver went down over 90% during its bear market in 1980s and 1990s.”

His conclusion: “I said before, commodities are the place to be. Stocks are not going to be very good. They have been bad for about 10 years. They are going to be bad for another 10 or 12 years. Commodities are the place to be and, therefore, commodity currencies are the best place to be, if you are going to buy currencies as long as they are well-managed countries.”

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