Debt downgrade wasn't a surprise, but market reaction was

This article first appeared in the St. Louis Beacon, Aug. 8, 2011 - Market watchers said Monday that they weren't particularly surprised by last week's decision by Standard & Poor's to downgrade long-term U.S. debt, but they didn't expect investors to react in such a strong, negative way.

From the minute the stock market opened, the bears ruled on Wall Street. The Dow Jones industrial average, which had taken a beating last week after the White House and Congress came up with a deal to raise the debt ceiling, immediately plunged into a triple-digit drop and kept plummeting until the final bell, when the Dow had plunged 634 points. The selloff accelerated after President Barack Obama made comments about the economic situation in early afternoon.

But while the S&P downgrade of long-term U.S. debt to AA+ from AAA may not have caught anyone who was paying attention off guard, the action on Wall Street did.

Fear, not facts talking

Joe Stieven of Stieven Capital Advisers in Des Peres said Monday's performance of stocks compared with that of long-term Treasury notes shows the sharp downturn can be laid more to emotion than to financial facts.

"Think about it," he said. "Wouldn't you think that a downgrade would be reflected first in the value of Treasuries? But Treasuries have rallied dramatically, while equity markets are weak. It has been a very perplexing, very volatile market all day long.

"In general, obviously there is a lack of confidence. However, the fundamentals are there. There are some very, very good values."

Howard Wall, a former vice president of the Federal Reserve Bank of St. Louis who now heads the Institute for the Study of Economics and the Environment at Lindenwood University, agreed that the issue in the wake of the S&P action is one of perception, not reality.

"The markets aren't downgrading the United States at all," he said. "The downgrade doesn't change the interest rate that the U.S. has to pay to borrow money, so in that sense it doesn't have a real effect. But it does signal lack of confidence and more uncertainty.

"I think this is a reflection of what is already happening. It's not really causing anything. I don't think the views of many people were changed by it, but it certainly is a slap in the face."

Not that the economic picture is particularly rosy, Wall added.

"It's not that good," he said. "It's not that common to have these two bad quarters like we've had in a row without bad things happening soon after. So I'm a bit worried because it doesn't seem like a temporary bump in the road. Every time we've had a slight bump in energy prices, bad things have followed.

"We had a big run-up in energy prices that started last year and went through October, and much later we have weaker growth. The recovery is very fragile. When energy prices spike up and stay up, that to me is the real thing that might be pushing things over the edge for an already fragile recovery. It may move us to another recession."

John Howe, a professor of finance at the business school at the University of Missouri at Columbia, said the move by Standard & Poor's might be causing so much worry because it isn't clear to the public how the decision was reached.

"There's a bit of a black-box element about what they do," Howe said. "They're not perfectly transparent about how they come to these things. The difference between AAA and AA+ isn't all that great anyway. I don't know what they would know that isn't generally known, so I suspect they are looking at those facts and coming to a different kind of conclusion."

Howe said the real effects of the downgrade might not amount to very much.

"We're still many, many levels away from junk-bond status," he said. "The possibility of default has been pushed off until at least beyond the election, and I suspect it has been pushed off significantly. You might see a little pick-up in interest rates, but I don't think it will be big. So the impact in terms of borrowing rates or deposit rates will be fairly small."

And he added that when it comes to S&P's conclusions, he doesn't have a whole lot of faith in what they have to say.

"I'm inclined to think that with something like U.S. Treasury securities," Howe said, "they really don't have any more information than you and I do, and therefore their opinion is not particularly important. If they were looking at a particular company, and doing it right, they might be able to find out more than we would be able to do."

Getting back on road to recovery

What does he see as far as the likelihood of the economy moving back into recovery?

"I think it's higher than a 50 percent probability that we will have a double dip," Howe said. "Officially, we've been out of recession, but it's been an anemic recovery."

Biggest Losers

Data from The Wall Street Journal

As far as the market reaction goes, a research report issued Monday by Stifel Nicolaus & Co. said the S&P move was irrelevant, and investors should concentrate on growth stocks.

The downgrade "has set hearts to flutter in the business press," said analyst Barry B. Bannister in the Baltimore office of the St. Louis-based firm, but "to profit in this age of social networking and mass media we urge investors to rise above 'Groupthink' on this issue."

Calling the action highly politicized, Bannister urged investors to examine the context involved, adding:

"Given the complicit role we believe the corporate side of the rating agencies played in the recent mortgage crisis, we equate their public actions to the zealotry of accounting firms in the wake of Enron, WorldCom and the destruction of Arthur Andersen in the prior decade. This posture is typical of the defensiveness of 'the accused,' in our view."

What will help break the cycle?

Wall says the federal government doesn't have many more levers to push, but if officials were to ask him what to do, he's got a little list.

"They've been out of tools for some time," he said, "and a lot of the tools they've been using have been misguided and never would have worked anyway. It sends shivers up my spine when I see a headline that Congress is going to turn its attention to jobs. If that means they are going to try to urge growth by building high-speed rail and things like that, we're in deeper trouble."

Such actions, he said, would result in more debt without having much effect on the economy except taking resources from the private sector. He'd like to see a reform of the tax structure, a halt to new regulations and drilling for oil in the Gulf of Mexico -- prescriptions that follow the GOP playbook. He is opposed to some of the administration's earlier incentives like what he called the "cash-for-clunkers nonsense."

Wall said the Bowles-Simpson commission on the economy had a good plan for taxes -- lower rates, broaden the base and get rid of deductions and loopholes. But he added:

"We should be cutting spending more than raising taxes. With the tax system we have, it is so horribly costly to raise an additional dollar, it might not even be worth it."

Raising tax revenue may be the most contentious issue separating Republican and Democratic views on reducing the debt and improving the economy long term.

Stieven's prescription for helping restore confidence in the economy is blunt: Stop arguing and emphasize facts, not opinion.

"We need a lower degree of political fighting," he said. "While Americans understand there are differences of opinion, having policy made out in public, on television, doesn't help. I think that's what has a lot of Americans confused.

"If I told you right now that the banking industry is as well capitalized as it has been in history, with as much reserve as it has ever had, would you believe it? It's true, because they have deleveraged and raised significant amounts of capital. It would be nice to have regulators come out and say that.

"Those are facts, not opinion. Opinions are like dirty socks: Everyone has them, and they all smell. Facts are facts, and they always win out over opinions and rumors. You have to make rational decisions."