Monday, August 8, 2011

US credit downgrade: a timely wake-up call?

The downgrade of America’s sovereign rating by Standard & Poor’s doesn’t tell us anything we didn’t already know. The US is in a weak and fragile recovery constrained by high household and sovereign debt. This has been the premise behind our expectations of many years of relatively weak economic growth in the US, and in much of the developed world.

The new part of the equation was, as we mused following the debt ceiling debate of recent weeks, the failure of politicians to develop, articulate and ultimately implement a credible long-term plan to achieve fiscal sustainability. Fiscal consolidation then becomes a series of short term measures that makes it difficult to achieve the important balance of achieving fiscal sustainability and supporting economic growth. S&P’s action at the weekend was as much an indictment on the political process, than anything else. Perhaps in time we will look back on this as being a wake-up call?

Given the economic fundamentals of the US are well-known they are already, to a large degree, reflected in asset prices. The US Dollar is weak and much of that weakness is structural, reflecting the drop in relative living standards that is the primary legacy of Global Financial Crisis.

Bond yields are low reflecting the low growth/benign inflation outlook and (still) safe-haven status of US Treasuries. If you’re going to sell Treasuries today, what are you going to buy? It has been our medium-term view, however, that US bond yields would rise over time as investors became increasingly focussed on fiscal issues. That would be reflective of a rising US risk premium. S&P’s actions may well front-load some of that premium.

On the other hand (don’t you love it when economist’s say that?) there may be a downward impact on yields as investors take this opportunity to reassess the US growth outlook. The consensus view on medium-term US growth is still too high in our opinion. We think trend growth in the US is now about 2.5% and developments over the weekend haven’t changed that view.

None of that stops a likely knee-jerk reaction to the downgrade as markets progressively open this week. Equity markets have already dropped significant in recent days and this won’t do anything to help sentiment. What’s cheap can always get cheaper.

One of the interesting things to watch in the days, weeks or months ahead will be how other countries, especially those who are still AAA-rated, respond. It could be that some decide to take a harder austerity line to protect their rating. While that sounds admirable, it is the wrong way to think about it. It’s not about how fast fiscal consolidation occurs, it’s all about having a plan that is credible and gives markets confidence that there is commitment to achieve it. That is all that’s really missing in the US and Europe and should be an easy fix. Should be….