Analyzing the Downgrade: Avoid “Panic Selling”

It is a culmination of events that are getting to investors, said Michael Hartnett, Chief Global Equity Strategist, Bank of American Merrill Lynch Global Research, in a Webcast hosted by BofA today. From the European debt crises and the debt ceiling debate to the downgrade, Hartnett said that while the downgrade itself changes growth prospects directly, it also affects confidence and raises recession risk. “The worry that we all have of course is that the U.S. Treasury yield is really the risk-free rate, so if you raise that risk-free rate, you’re going to lower the appetite for risky assets right across the curve.”  It’s a moment in which growth and risk appetite are weakening, and that normally warrants some policy intervention to arrest that decline, he added.

“The world, not just the U.S., is in uncharted waters, and all the ramifications of a debt downgrade of the global reserve currency are unfathomable at this time,” said Doug Coté, Chief Market Strategist at ING Investment Management in a statement from the company.  At the same time, Coté notes, many fundamentals remain strong, and he cautions investors to “avoid panic selling” and stay focused on maintaining a properly diversified, long-term strategy.  Markets will likely be slow to react to the real implication of the debt downgrade.

ING pointed out the following positive indicators:

• Corporate profits have found a sustainable source of growth in the global economy.
• In the global economy, emerging markets in particular have low debt.
• Manufacturing, although volatile, remains a pillar of the expansion in the U.S. and globally.
• Consumers are resilient and are at near record highs in income and spending despite 9.1% unemployment.

UBS Global Asset Management believes that in the short-term, the credit downgrade will generate further volatility in a market already dealing with a number of broad macroeconomic issues. Longer term, the view is more complicated; on one hand, the implications of the downgrade, though still unclear, are likely to be limited. On the other hand, UBS believes this event is indicative of a broader concern revolving around sovereign fiscal discipline. This is a topic with no simple resolution, and one that will likely continue to be a focus of attention in the foreseeable future.

The following observations were made by several analysts:   

• At the asset class level, the potential gains of carrying an overweight exposure to equities have diminished, while the risks have increased. Mary Ann Bartels, Head of Technical Analysis, BofA Merrill Lynch Global Research, said in the BofA Webcast that treasuries continue to be a very safe asset; in fact, the downgrade is ironic because there is a positive response from treasuries - they are a very safe asset for investors to continue to own. The negative response/lack of confidence is with equities, she said. We don’t need to go into “panic mode,” she said, but suggested investors look at their portfolio with their adviser and check to see if there are any tactical moves to make.
• UBS noted that the timing of the downgrade is aclear negative for risky assets, given the sovereign debt issues in Europe. The credibility of policy makers has been undermined by the conflicts/delays in Europe and the US, which has eroded the confidence of governments and central banks.
• Equity markets—which have traditionally anticipated economic trends—have instead become reactive to economic data points, developing a coincident relationship.
• U.S. corporate operating performance remains strong. U.S. corporations have combined strong expense and working capital management with exposure to international markets that have better growth, to post sustained earnings growth despite the weaker-than-expected economic data.

Hartnett from BofA Merrill Lynch concluded that there are three things to look for; first, the bond yield to stop falling–“That’s critical to show that the economic situation is not falling any further,” he said.  Same goes for the banking stocks, because they’re the most cyclical part of the equity market. The third indicator is oil prices, which he said have reversed dramatically and that gas prices should go down in the second half, which might spur some consumer spending. “Bond yields, banking stocks, and oil prices are key indicators of the economy’s direction,” he said.