Life after the U.S. rating downgrade

Aug 12, 2011

By Nipun Mehta, Reuters

The unthinkable (for some) happened last week when the U.S. economy was downgraded from ‘AAA’ to ‘AA+’ with a negative outlook by Standard & Poor’s, one of the three large global rating agencies.

That led to an interesting situation where European economies like France and the UK are rated higher than the U.S., despite huge concerns about their financial condition. The event would undoubtedly have hurt the American ego, particularly since S&P announced that there could be more downgrades in the offing.

That this was an event that was imminent is accepted by many, but what is in store for the global economy and the Indian economy going forward?

There are several concerns that will keep haunting the central banks, the equity markets and governments around the world. These include:

- What if the UK and France are downgraded too?

- Will the other two rating agencies also downgrade U.S. in a few weeks’ time?

- How long before some U.S. companies and state and local governments get downgraded?

- Why is Spain still rated AA, Italy A+ and Ireland BBB+, when India and Brazil are rated ‘BBB-‘, by Standard & Poor’s? Will these European economies be downgraded soon?

- At ‘BBB-‘, why are India and Brazil rated the same as Portugal which has serious economic issues?

While a downgrade of one or more of the European economies is waiting to happen, one can rest assured that any such event can and will have a severe contagion effect on the other EU economies due to their linkage. Several European banks would undergo a rating change too under such circumstances.

The fact remains that even as far as the EU is concerned, the situation is delicate and we continue to tread on thin ice. Amidst all this is the bigger question of how long the U.S., being the world’s largest economy, will take to come out of the recessionary condition. One could just see another round of QE3 in the U.S. or a round of bank funding that we witnessed by France and the UK in 2008.

The other issue is of fiscal discipline by these countries which are facing a deep financial crisis. The easiest thing to reduce deficits is to raise taxes. What is always difficult for governments is to reduce expenditure as this could further lead to potentially slowing down the economy. It’s always a fine balance that needs to be created between inflationary pressures (that events like quantitative easing measures create) and recessionary conditions (which reduced expenditure can potentially create).

Given the global concerns, world equity and commodity markets will be affected even if they may not be directly impacted by the downgrade. Global currency and bond markets have already seen considerable volatile movements due to movement of large funds into and out of them.

While crude and commodity prices have eased post the event, how long they continue to fall, or sustain at lower levels will determine the inflation levels in several economies, as well as profitability of several companies in the manufacturing sector.

Select Asian economies on the other hand presently face the opposite task of inflationary pressures due to fast paced growth. It is due to this that equity markets in select Asian economies will possibly stabilise faster than the European or U.S. markets.

Risk aversion has ensured that funds move to safer asset classes like gold. One should not be surprised if part of these funds move to emerging economies once there are signs of stability in the global markets.

As far as Indian markets are concerned, once the global negative news subsides, it will be a choice between fundamentals, liquidity and valuations. While interest rate concerns, domestic scams and lack of decision making by the government continue to pull down sentiment, fundamentals remain strong and valuations are becoming increasingly attractive.

What is missing is the FII liquidity which can drive the markets upwards. In a situation where both the U.S. and EU face deep concerns over their fiscal policies, it may not be too long before emerging markets and India start attracting flows. We do need to closely watch policy action by the RBI.

Nibble into the equity markets if you have the risk taking ability to see some more volatility arising out of possible announcements from the U.S./ EU economies. If not, wait till there is greater stability in the global markets.