How the Downgrade Trickles Down To Consumers

In isolation, Standard & Poor's recent downgrade of the United States' credit rating to AA+ really doesn't mean much, past the possibility of some quick "dislocation drops" on the news. After all, it's not like the American financial situation was a mystery before last Friday's downgrade was announced.

Additionally, Fitch's and Moody's both reaffirmed their AAA ratings. As long as they both stay at AAA, there won't be much that compels anyone to sell their Treasuries. And even they follow S&P, just those institutional investors that can only buy AAA securities could be forced to sell. Chances are that, much as the Federal Reserve allows an American exception for owning Treasuries even without the AAA rating, so will other institutional regulators.

The reason for that exception is simple. The U.S. government borrows money denominated in U.S. dollars. That same U.S. government also runs the U.S. Treasury, which prints those dollars. Thanks to that convenient arrangement, the probability of "default" is extremely low, no matter what letter grade is assigned to that debt.

The Real Risk to Ordinary People

The real risk is devaluation: Essentially printing tons of currency to reduce the worth of the U.S. dollar, in order to make that debt cheaper in real terms to pay off. And while that might sound harmless on the surface, it can wind up being quite painful for ordinary people.

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You see, every dollar that the U.S. government borrows has to be lent by someone else. Those lenders won't be willing to accept low interest rates if they expect the dollars they'll get paid back with to be worth significantly less due to devaluation when the debt matures. As a result, if investors fear devaluation, interest rates will rise.

How high will they go? Well, as Motley Fool contributor Morgan Housel recently pointed out, a decent first guess would be around 0.7 percentage points, all else being equal. With about $14.6 trillion in total outstanding debt, that works out to a little more than $100 billion in additional annual interest costs, just to service the existing debt as it rolls over.

Aside from the higher long-term taxes that implies, it also showcases where the real risk is to you from downgrades to the United States' credit rating.

Feeling the Pain: Mortgages, Credit Cards, Jobs

As investors demand more interest from debt denominated in devaluing U.S. dollars, all U.S. dollar denominated debt will be affected, except pre-existing fixed-rate loans. So if you need to carry a balance on your credit card, expect your rate to rise. If you need a new mortgage or have a floating rate one, expect rates to rise.

On a similar note, a devalued currency is simply worth less on the international market, which means that as the dollar devalues, imported goods will cost more, as well. Or in other words, you'll both pay more to borrow and pay more to buy.

This, of course, will affect the entire country, and that means more tough choices ahead in terms of where and how much companies will be able to profitably invest for their future. You may have heard it said that "corporate balance sheets are deleveraging," which is a fancy way of saying that companies have been busy paying down their debts. They're doing that out of concern that if they borrow more in the future, they, too, will be forced to pay higher rates.

While that shores up their individual corporate financial strength, every dollar put toward debt reduction is a dollar not spent on investment, or on jobs to implement those investments.

That said, every crisis brings an opportunity with it. If your own debt is under control and your income secure, this might be an excellent time to own debt-light, foreign-domiciled companies.

How to Insulate Your Portfolio

For American investors looking to take advantage of both the likely devaluing dollar and the expected increases in the cost of debt, adding some foreign stocks would help insulate your portfolio from both issues. Here are some of the stronger ones, with moderate debt levels and good earnings prospects:

Source: Capital IQ, a division of Standard & Poor's.

Looking at those companies as a portfolio adds additional benefits, too. With headquarters in different countries, you're insulated from local political risks. With business lines in different industries, you're insulated from massive shifts in consumer behavior. And with decent earnings, solid balance sheets, and promising long-term growth prospects, you've got a collection of stocks with the potential to reward their owners over time.

Whatever fallout there may be from the debt downgrade and the potential devaluation of the currency will eventually pass. It always does. And if your own financial position is secure enough to enable you to invest throughout this mess, there may be an opportunity now. After all, the depths of a crisis often provide an opportunity to pay reasonable prices to buy the companies that will lead the way in the next expansion.

At the time of publication, Motley Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. Motley Fool newsletter services have recommended buying shares of ABB.

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