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The US Debt Downgrade and What It Means

By Gus Krafve


May 11th, 2011

From an optimist’s point of view, April 18, 2011 could be the catalyst to get the US government on track to being a better steward of our nation’s finances.  That was the day Standard & Poor’s officially revised its outlook on US long-term debt from stable to negative.  This negative outlook means that there is roughly a 33% chance that our government debt will be downgraded from S&P’s highest rating, AAA to AA+. While S&P reaffirmed that U.S debt is still AAA rated, the agency is concerned about our country’s ballooning deficit and lack of a deficit reduction plan. 

 

The US government has continued its status quo of deficit spending and our country’s debt has doubled in the past two years from $7 Trillion to over $14 Trillion.  The markets initially reacted negatively to the news with the Dow Jones Industrials falling over 200 points.  The stock market, however, quickly recovered over the next couple weeks with the S&P rising nearly 5% by the end of April.  The year-to-date performance numbers as of April 30 for the major market indices are as follows:

 §  S&P 500                                    +9.06%

 §  S&P MidCap                              +12.33%

 §  S&P SmallCap 600                    +10.51%

 §  Dow Jones Ind. Avg.                  +10.65%

 §  NASDAQ Comp.                        +8.32%

 §  EAFE (Foreign Developed)        +2.91%

 §  Long-term Treasuries                +1.01%

 §  Barclay’s High Yield Bonds        +5.49%

 §  Barclay’s Aggregate Bond          +1.70%

 §  Gold                                            +9.43%

 §  CRB Commodity Index              +9.23%

 §  U.S. Dollar Index                         -7.60%

Despite the solid returns in the equity markets, the following concerns prevent us from becoming overly bullish on stocks at this point:

 

  1. The Fed’s second round of Quantitative Easing stimulus ends in June;
  2. Continued high energy prices are taxing consumer spending which makes up nearly 70% of US economic activity;
  3. A looming debt crises in Spain, Portugal and Greece;
  4. Many stock indices have already more than doubled in two years;
  5. Consumer and government debt remain at elevated levels.

 

Economists have long studied the affect a country’s government debt has on the growth of its economy.  They have found when debt-to-GDP exceeds 90%, it acts as a hindrance to economic growth.  Developed economies that go beyond that 90% threshold have growth rates of two percentage points lower, on average, than economies that have not yet crossed the line. Currently, the  US debt-to-GDP  ratio is approximately 100% which is the highest level since the end of World War II. Unless the US reduces its debt to a more manageable level, it will likely be difficult for the stock market to sustain on a long-term, secular bull market.