Moves to make if the U.S. gets downgraded again

Source: MARKETWATCH

By Robert Powell, MarketWatch

Last Update: 12:01 AM ET May 31, 2012

BOSTON (MarketWatch)The rating agencies have put the U.S. on notice, as Forrest Gump might say, again: Come up with a credible plan to deal with the budget deficit or face yet another downgrade. And that warning has investors wondering what, if any, moves to make with their money should Uncle Sams credit rating get dingedagain.

Weve been down this road before. A little less than a year ago the rating agencies, after issuing a similar warning, did in fact downgrade the U.S. credit rating (in the case of Standard & Poors, by one notch from triple A to double A) and nothing all that bad happened to most of our investments. Yes, there was a good deal of volatility last August. But, ultimately, with few exceptions, the sky didnt fall. Stocks, bonds, and commodities didnt collapse.

There was no rapid re-pricing as some money managers said would happen when the credit agencies followed through on their warnings. Medium- to long-term, it has not appeared to have any substantive impact, said Greg Gocek, a charted financial analyst and independent investor in the Chicago area.

Now, many experts dont expect history to repeat itself. Investment professionals and others think lawmakers will reach a temporary agreement on the debt limit and avert another downgrade.

Read one such report, in The Hills On The Money blog.

A downgrades unlikely

Whats more, the probability of a major budget deal being reached in early 2013 is higher than usual for at least four reasons, according Jeffrey Kleintop, a chartered financial analyst and chief market strategist with LPL Financial.

One, the economic impact of the many scheduled tax increases and spending cuts is already set to begin in 2013, he said. The fiscal headwind comprising both tax increases and spending cuts under current policy totals more than $500 billion, or 3.5% of GDP. The 2013 budget changes, primarily consisting of tax increases, are already in the law and would need to be changed to mitigate or restructure them to be less of an economic drag. If not, a return to recession may be looming in 2013.

Two, the debt ceiling will be hit again in early 2013 and require legislative action to approve an increase.

Three, the rating agencies have warned that they will be watching in 2013 for the U.S. to take actions to return to a path of fiscal sustainability.

And four, President Barack Obama and a newly elected Congress will have maximum political capital to make it happen in early 2013.

The most likely outcome is a fiscal tightening that exceeds 1% of GDP is likely next year, said Kleintop. In fact, he predicts a fiscal tightening of more than $200 billionwith about half from tax increasestotaling about 1.3% to 1.5% of GDP. From his perspective, the $200 billion is made up of the likely expiration of the payroll tax cut ($110 billion), a reduction in discretionary spending (of about $80 to $90 billion), and the imposition of the 3.8% surtax on investment income from high earners ($21 billion).

This combination of about $100 billion in tax increases and $100 billion in spending cuts may be the sweet spot for markets, Kleintop said. It is significant but not enough, by itself, to cause a recession; it may allay the immediate concerns of the rating agencies and avert a downgrade of our debt, and it may boost confidence that we can address our long-term fiscal imbalances and return to the path of fiscal sustainability. This is why the makeup of Congress is so important as Washington attempts to avert the budget bombshell from going off and taking the economy and markets with it.

But if there is a downgrade ...

Still, there are some things to consider if there is a downgrade.

For instance, if Uncle Sams debt gets downgraded, so too would government-sponsored debt. Agency issues like GNMA, FNMA, and FNMC basically have government guarantees parallel to Treasuries and their ratings would likely fall sympathetically to match, said Gocek.

Theres also the sovereign ceiling rule. With few exceptions, private debt is not allowed to have a higher ceiling than the government, said Gocek. So raters such as S&P would downgrade the top corporate ratings to parallel the highest rating on Treasuries. Moody is more flexible on this issue.

Municipal debt would be affected too. The highest rated issues would also like have some negative effects, with the negative impact potentially even more detrimental on the weaker rated issues such as Illinois or the city of Chicago, Gocek said. In addition, pre-refunded, or what are sometimes called escrowed, municipal bonds which are secured by proceeds in federal instruments in an escrow account are contractually equivalent to U.S. government obligations and would fall in lock-step.

And, the ratings on money-market funds likely wont be affected, but there could be strains on their liquidity, said Gocek.

Meanwhile, Jeff Witt, a CFA charterholder and director of research at Private Asset Management Inc., said positioning a portfolio for a possible downgrade needs to be broken down into two distinct steps: One, prior to or concurrent with the downgrade and two, subsequent to the rating downgrade.

Prior to and concurrent with the downgrade, investors would likely be prone to become more defensive, liquidating some riskier assets such as stocks and junk bonds and moving money into safer investments such as cash and money markets, Witt said. Counterintuitively, this flight to safety will likely increase demand for Treasuries, driving prices higher and yields lower, he said. This is similar to what happened in August 2011, at the time of the last credit downgrade. One reason that this occurs is the size of the Treasury market is such that it is the only viable option when there is a broad-based flight to safety.

In addition, Witt said, the Japanese bond market would also be expected to benefit from the flight to safety and he expects that the yen would appreciate relative to the U.S. dollar, also similar to what we saw last year.

After a downgrade, however, Witt predicts that equities and riskier assets would outperform safer investments. The extension of the stimulative programs and tax breaks should serve to boost near-term GDP growth, resulting in increased corporate profits, Witt said. Additionally, an extension of the so-called Bush tax cut would keep tax rates lower on capital gains and dividends, offering a relative advantage to fixed-income investments.

Others, meanwhile, have a different strategy to deal with the prospect of a U.S. credit rating downgrade. Jonathan Masse, a senior portfolio manager at Baochuan Capital Management is recommending a buy-write options strategy.

From his perspective, equity markets have been unjustly whacked in the wake of the Greece/euro-zone fears and the volatility/fear indexes have popped over the past three weeks.

He recommends buying iShares MSCI Emerging Markets Index , iShares FTSE/Xinhua China 25 Index , and iShares MSCI Brazil Index that have sold off and the options are trading rich. Go long those ETFs and sell calls with rich premiums as a hedge, Masse said.

Dont make any moves at all

Still, others say it doesnt make sense to make any money moves in anticipation of something happening. Repositioning a portfolio in anticipation of another downgrade of U.S. government debt may not make sense for all investors, said David Zuckerman, a principal and chief investment officer with Zuckerman Capital Management. The rating agencies don't have a good track record of accurately assessing credit risk, and the effect of another downgrade is difficult to predict.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets here.

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