By Alex Dumortier,The Motley Fool
On Monday, ratings agency Standard & Poor's announced that it was downgrading its outlook for the U.S.' sovereign credit rating from stable to negative, and put the odds of a ratings downgrade within the next two years at 1 in 3. The news spooked stock investors.
What's the significance of this announcement? I asked two of my Foolish colleagues, Morgan Housel and Matt Koppenheffer, to weigh in on the following question:
Will the U.S. Lose Its AAA Rating?
Morgan Housel: It shouldn't, because it doesn't have to. Our debt problems are massive, but still very solvable. I also think most people underestimate this country's ability to pull it together and act when it becomes truly imperative. You see this during wars, terrorist attacks, financial crises, etc. Parties hold hands and get it done when things get really ugly. Congress won't act today because there's no crisis -- the Treasury can borrow debt at a lower interest rate today than it could when there was a budget surplus 10 years ago. When interest rates spike and a true crisis stares us in the face, I think you'll see quick action. Maybe that's being naive, but I imagine it's how this story will play out.
That said, downgrading America's debt isn't up to Congress or the president. It's up to the ratings agencies. Not only do the raters have an abysmal track record, but I worry about this on an egotistical level. The person responsible for downgrading the U.S. will overnight become the most famous analyst on the planet. Knowing the personality of people who go into high finance, I can't help but wonder if this will be a driving factor. That might sound conspiratorial, but it's what happens when two firms (Moody's and S&P) hold duopoly power over the nation's debt ratings. You get despots.
As for actual default, history shows the best indicator of future default is simply past default. The U.S. hasn't defaulted on its debt in modern history, so we're doing well there. We've shown the willingness to make tough decisions during past bouts of debt overload, particularly after World War II and in the early '90s. The bond market has a good memory of this stuff, as it should. As I wrote last week, the market will forever be kinder to Ford (F) than it will General Motors(GM) , only because the former made tough choices while the latter dug its own grave. There's a similar analogy in there when comparing the U.S. to countries like, say, Greece.
Matt Koppenheffer: Earlier this week I spoke pretty confidently that the 1-in-3 odds that Standard & Poor's put on the U.S. losing its AAA credit rating was silly. To be fair, I hold none of the cards in that game and S&P holds them all -- so if the folks there want to downgrade the U.S., then, by God, they will.
The bigger question though, may be if anyone really gives a rat's hindquarters whether S&P goes ahead with a downgrade. In the fallout from the financial crisis, S&P, Moody's (MCO) , and Fitch have bent over backward to be clear that their ratings are just opinions and they can get things very wrong (ya think?). While the stock market sold off in the wake of the outlook knock, the bond market charged right ahead, apparently flipping S&P the bird as investors continued gobbling up low-yielding Treasuries.
In the end I can't say whether the S&P will downgrade the U.S. I can say that I don't think it should -- there's an exceedingly low likelihood that the U.S. won't make good on its debts and there's no reason that it shouldn't be among the top tier of borrowers. What that doesn't mean, however, is that Treasuries are good investments. With yields at ridiculous lows and specter of inflation far from nonexistent, I think Bill Gross has the right idea.
Alex Dumortier: Although the stock market reacted sharply to the news, the bond market took it in stride. By the end of the day, the yield on the 30-year Treasury bond had increased all of 3 basis points to 3.39% (1 basis point = 1 hundredth of a percentage point.) Frankly, I'm surprised equity investors were selling stocks on the announcement, which was long overdue. It's not exactly a surprise that the U.S. can't afford to stay on its current fiscal trajectory. As long as the government does not address the issue in a coherent, forceful manner, the outlook for the U.S.' credit rating can't be anything other than negative.
Will the U.S. lose its AAA rating? I think the odds of that happening are pretty slim (but not zero), and certainly less than S&P's estimate. The budget deficit and national debt are now center stage as political issues, and I don't see that changing anytime soon. These problems are far from intractable, but the solutions are unpopular (something politicians abhor). Nevertheless, S&P's decision heaps a little extra pressure on the politicos to act with purpose rather than simply trying to score political points.
My biggest fear is that any resolve will be channeled into inflating the problem away. Under that scenario, default risk is not the issue; the problem is getting repaid in dollars with a much reduced purchasing power. As Berkshire Hathaway (BRK-B) CEO Warren Buffett said at the end of March:
I would recommend against buying long-term fixed-dollar investments. If you ask me if the U.S. dollar is going to hold its purchasing power fully at the level of 2011, 5 years, 10 years or 20 years from now, I would tell you it will not.
Owners of the iShares 20+ Year Treasury Bond ETF (TLT) , you've been warned!
It's your turn: Give us your opinion in the comments section below. Alternatively, if you want to explore this topic further, Morgan Housel answers the $14 trillion dollar question: Will the U.S. default on its debt?
This roundtable article was compiled by Fool contributor Alex Dumortier, CFA, who has no beneficial interest in any of the stocks mentioned in this article. Berkshire Hathaway and General Motors are Motley Fool Inside Value recommendations. Berkshire Hathaway, Ford Motor, and Moody's are Motley Fool Stock Advisor picks. The Fool owns shares of Berkshire Hathaway, Ford Motor, and Moody's. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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