US: What would a default and/or downgrade mean for investors?

29th July 2011

So will the Republicans and Democrats manage to co-operate in time, and if they don't, what will that mean for the markets as a whole and for the investor?

A default would send shockwaves through global financial markets, especially at a time when the US economy is still struggling to recover from the worst recession in decades, reports the Independent.

But will there be a default, even if the deadline isn't met?

Mindful Money blogger Gemma Godfrey says on her blog: "Failing to raise the ceiling wouldn't cause an immediate but an eventual default. In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits.

"…Yet while most investors think a last-minute deal to raise the debt limit will eventually emerge, the difficulty of reaching an agreement may leave a lasting impact on investor sentiment. "

If there is a default, what impact would this have on the market?

Chairman of the Federal Reserve, Ben Bernanke, said last Thursday a Treasury default would be 'a calamitous outcome'. He added: 'It would create a very severe financial shock that would have effects not only on the US economy, but the global economy,' reports Money Observer.

However, so far US Treasuries have failed to react dramatically to the delay. Keith Wade, chief economist at Schroders, says: "One explanation for the lack of reaction in US Treasuries would be that investors simply do not believe that politicians will fail to lift the debt ceiling. Whilst this may show touching faith in the ability of a divided Congress to do the right thing, this is looking like more of a risk as the deadline approaches and the gulf between Republicans and Democrats remains."

However, David Harris, senior portfolio adviser for US fixed income at Schroders, said: "The risk of a policy mistake leading to a missed interest or principal payment would have a very negative and lasting impact on US credibility, even if the experience is brief."

What about a ratings downgrade?

Gillian Tett says in the Financial Times (paywall): "Right now, it seems unlikely that Treasury bonds would become illiquid after any downgrade; after all, this is the deepest bond market in the world. But a downgrade of US debt could, ironically, force some asset managers to sell more risky instruments (such as triple B bonds) to maintain average ratings benchmarks in their portfolios." 

Keith Wade from Schroders says: "S&P, Moody's and Fitch say they would downgrade the US in the event of failing to lift the debt ceiling and a coupon or principal payment is then missed. S&P have also said they would put the US in selective default in these circumstances. Should this occur and be followed by other agencies there could be an almighty scramble for the remaining AAA rated securities with some investors having little option but to sell Treasury bonds."

Gemma Godfrey adds on her blog: "Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened to reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA' status and ‘stable' outlook', any downgrade would threaten its role as the safest place to store savings."

"…In its extreme, uncertainty could spark another financial crisis as well as put the dollar's status as the world reserve currency at risk."

What should investors do?

Even with a potential U.S. default just days away, there are tried-and-tested strategies investors can use to help insulate their portfolios from market shocks.

Yet with so much volatility in the markets, investors could do worse than to sit on the sidelines to await more concrete news.

Brian Dennehy, from IFA Dennehy Weller & Co, says: "We wouldn't recommend anyone start jumping around now based on US debt talks. Our clients reduced risk substantially some time ago because of the risks associated with the Eurozone, which are far more intractable – so we aren't making any more adjustments.

"The markets, at least for now, have much greater confidence in the US pulling itself out of the mire – that does not apply with the Eurozone.

"In general investors need to figure if they have investments or funds which can ride through this. For example, if I'm in equity funds invested into big global brands, with limited or no debt, loads of cash, and above-average dividends, I can ride this out."

Juliet Schooling from IFA Chelsea Financial Services says: "While failure to reach an agreement would certainly result in a market fall, I expect we will see a rally in the more likely outcome of a resolution. However, then of course there is the next hurdle with the downgrade issue, which would negatively impact already fragile US growth.

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