Asset managers assess impact of US downgrade

S&P’s move to lower the US’s long-term credit rating is seen simply as a reflection of reality. While further market volatility is forecast this week, some see opportunity in dislocation.
Asset managers assess impact of US downgrade

The historic decision by Standard & Poor’s to downgrade the long-term sovereign credit rating of the US one notch to AA+ came as little surprise to Asian asset managers. What was of greater surprise was that the rating agency left it on negative outlook.

Aside from raising awkward questions about what can truly be deemed risk-free, in itself the downgrade was not seen as significant. “It is perhaps the inevitability [of the downgrade] that is significant,” says Peter Elston, Asian investment strategist for Aberdeen Asset Management.

The move, which had been speculated upon, duly arrived shortly before 9pm New York time on Friday, August 5. It’s the first time S&P has lowered the grade since it started rating the United States in 1941.

“No, it was not a surprise,” says Michael Dommermuth, president and head of Asia for Manulife Asset Management. “From a practical standpoint, however, Treasuries remain a relatively safe haven in the context of global debt pressures.”

Asian asset managers had largely positioned their portfolios defensively in the run-up to this downgrade anyway, many with a home-region bias and a preference for companies exposed to Asian rather than Western demand. The impact on portfolios was expected to be immaterial.

“Although paradoxically the downgrade may, in the short term, result in a flight to safety into the US dollar, we think the medium-term trend is for Asian currencies to strengthen against key developed market currencies, driven by their stronger fundamentals,” notes Elston.

He points out that credit rating agency Egan-Jones downgraded the US three weeks ago, while Chinese agency Dagong did the same last week.

“Sadly, S&P’s move lacks the credibility such a move should warrant because of numerical errors that the White House, keen to disparage the move, pounced upon,” he adds.

But S&P tells AsianInvestor there were no numerical errors. Rather, the day after the downgrade the agency opted to issue a denial that its decision was affected by a change of assumptions regarding the pace of discretionary spending growth.

“The primary focus remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the US medium-term fiscal outlook,” the agency stated.

Andrew Tan, deputy chief investment officer of Harvest Global Investments, believes it’s inevitable that the other two big rating agencies, Moody’s and Fitch, will follow S&P’s lead.

“The writing is on the wall and it is too obvious for any normal investor to ignore,” he says. “A universal downgrade will eventually become consensus.”

While Moody's and Fitch have already affirmed their AAA rating, additional downgrades would be bad as they would be indicative of the US's inability to get its fiscal situation on a sustainable path, notes Steve Walsh, global CIO at Western Asset.

Still, such moves are hardly something investors have come to base their decisions on, given that rating agencies were widely seen to have failed to rate mortgage-backed securities correctly before the outbreak of the global financial crisis in 2008.

“One doesn’t need rating agencies to spell out what is patently obvious, that in balance sheet recessions, government’s fiscal positions are one of the victims, particularly if they were not strong enough to begin with due to not building up cushions in the good times,” says Elston.

“What is far more significant is the chronic structural weakness in private demand in key Western economies as a result of the deleveraging that occurs following the bursting of multi-decade, credit-fuelled housing booms.”

Market impact
Anthony Ho, deputy CEO of China Asset Management, believes S&P’s downgrade had largely been priced in, with the MSCI World Index having plunged 14% since its peak in April. It comes after S&P assigned a negative outlook to the US's long-term sovereign credit rating on April 18.

“With the dramatic sell-down in the past week, with the MSCI World Index dropping by 9% and individual stocks dumped indiscriminately by investors, market valuation has become more attractive and there are an increasing number of mispricing opportunities at the stock level,” Ho says.

He notes that MSCI Asia ex-Japan and MSCI China are trading at 12 times and 10 times 2011 earnings respectively, which are at the lower end of their historical trading ranges.

“The current environment is actually the best time for our investment team to add value for our portfolios and to pinpoint investment opportunities from a bottom-up perspective,” he adds. “No doubt stock markets will be volatile in the short term, but risks and rewards are increasingly favourable for long-term investors.”

On the question of whether it had anticipated S&P’s move, Mark Konyn, Asia-Pacific CEO of RCM, a unit of Allianz Global Investors, says the firm had it as a 50-50 outcome.

“Our initial view was that a downgrade by a single notch would not impact the market significantly, but that further downgrades could prove more problematic,” he says.

S&P did raise the prospect of a further downgrade to AA within two years based on a downside scenario featuring less favourable macroeconomic assumptions, including that a second round of spending cuts of at least $1.2 trillion does not happen and higher nominal interest rates for US Treasuries.

“We will be looking closely how the markets react to the [downgrade] news this week, particularly in context of the very low yields on Treasuries and the flight to quality witnessed this past week,” adds Konyn.

Walsh of Western Asset says the firm's response to the downgrade will depend on how the market responds. "Most importantly, if Treasuries were to sell off meaningfully on the news, we would be inclined to extend duration by buying them," he states.

He notes that the downgrade came sooner than Western Asset anticipated, but also feels it was largely priced in. "It is possible that Treasuries will sell off initially with the curve slightly steeper, but we believe the volatility will be short-lived as markets return to evaluating fundamentals, growth and inflation, and even the problems in Europe."

Warren Bird, co-head of global fixed interest and credit at First State investments, points out that a rating change from AAA to AA has negligible impact on bond valuations or exposure limits.

"AA-rated issuers are very high quality credits," he says. "While the US needs to make sure its future fiscal policy and debt management continues to support such a strong rating, we believe most of the press coverage of what this means in economic and financial terms is grossly exaggerated."

Asked what the near-term impact might be on financial markets, he replies: "That depends on whether most of the market thinks like we do about this or is spooked by the exaggerated sense of panic the world's press are trying to create. We caution against putting too much significance on S&P's opinion."

CEO and co-CIO Mohamed El-Erian of Pimco, which in April revealed it had been betting billions against US Treasuries, says that immediate operational consequences of the downgrade include re-coding risk and trading systems and evaluating collateral and liquidity management.

"Global financial markets will open [today] to a changed reality," he wrote in the Financial Times. "Animal spirits, dampened already due to the debt ceiling debacle and European crisis, will further retrench. Key market segments will be closely watched, including the money market complex and the reaction of America's largest foreign creditors."

One development that managers will be watching for will be whether Asian government bonds tighten up this week given their relative attractiveness.

Yet the question of how the downgrade itself would impact financial markets was viewed as a hard one to answer given other factors in play, including the European debt crisis and US economic weakness, as well as fears that key emerging economies may not be able to provide support.

“I suspect the downgrade will not surprise markets, but that is not to say they won’t continue to be roiled in the short-term by other forces mentioned,” says Elston.

Tan, of Harvest, expects some dislocation in the short-term. “The 10-year Treasury yield may still trend lower and equities as an asset class may be out of favour in the short term,” he says.

Harvest’s investments are entirely focused on Asia and China, and Tan reflects that any near-term volatility only underpins the firm’s long-term optimism on Asian growth and currencies.

“It will encourage rethinking to pension and passive investors,” he adds. “The biggest bulk of global equities and fixed income indexes remain in US dollar denomination.”

He points to the loss of a AAA rating for the global reserve currency as an inconvenient truth that could act as a wake-up call to Asian central banks which have been accumulating foreign reserves as a way to limit currency appreciation in view of a depreciating dollar.

“The longer-term trend is very clear,” he states. “Asian central banks and sovereign wealth funds will be diversifying their currency baskets, while it may make more sense for Americans to hold some Chinese yuan.”

Tan reiterates Harvest’s preference for domestic growth over global growth, and says the firm has been strategically increasing its investment into Southeast Asia “where we can find ample companies with low correlation to US growth” as well as exploring frontier markets.

“Bottom-fishing is never easy,” he says. “But we are sure we should buy when policymakers are panicking. Don’t forget, there are always several last resorts available to the policymakers.

“We believe the gap between the emerging and developed economies will continue to close,” he concludes. “No matter if it is a developed grade or an emerging grade, as long as it can sustain its finances it is a good grade.”

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