Analysts at Barclays Capital expect the United States to lose its "AAA" credit rating as a compromise plan is passed by Congress that leads S&P to cut its rating on U.S. debt. But what would that mean for investors?
In a bid to understand the ramifications of such a cut, Barry Knapp, the head of U.S. equity strategy at Barclays Capital, has researched back as far as 1998 in order to look at the effect that Moody’s downgrade of Japanese debt had on that nation following the collapse of Long Term Capital Management (LTCM).
Knapp said using the Japanese example to understand the possibilities for the U.S. are “fraught with peril,” but his observations still make for interesting reading.
“Macroeconomic fundamentals were the major drivers of asset prices, rather than the ratings downgrade,” said Knapp in a research note on Wednesday.
“At first blush, we were struck by the massive underperformance of JGBs (Japanese Government Bonds) relative to German Bunds and sharp steepening of the 2-year and 10-year JGB yield curve, which implied that the downgrade did have a significant impact on longer-term yields,” Knapp said.
While yields rose, so did the Nikkei and yen, according to Knapp, who noted that a rebound in Japanese industrial production began in 1998 that dragged Japan out of recession by early 1999.
As a result, the move in Japanese bonds was in Knapp’s opinion due to Fed easing following LTCM’s collapse and Japan’s emergence from recession.
“The initial reaction for Japanese equities in the two weeks following the downgrade was positive, underscoring how other factors were driving the markets. However, within a couple of weeks, equities were struggling, again, likely because it was becoming clear that the first round of bank recapitalizations (in early 1998) were insufficient, setting the stage for a second round (in early 1999),” he said.
Banking stocks weighed on the Nikkei until the recovery took hold and the second round of bank recapitalizations had occurred.
“Once the recession ended and the second round of bank recapitalizations occurred, the yen was right back to where it started before the downgrade,” Knapp said.
With the S&P refusing to take fright at the debt talks in Washington and trading in a range between 1250 and 1350 Knapp has been fielding a lot of questions about why the U.S. equity market has remained so resilient.
“Our answer is that earnings season is off to a good start. We do not think this will last, but not because of the political risks. Instead, we expect the macroeconomic fundamentals to again become the primary driver of stocks, bonds, and the dollar, perhaps as soon as the GDP report, followed by Friday’s July employment report,” said Knapp
“Our expectation on the debt negotiations is a compromise solution that avoids default but not a downgrade. So, if Congress falls short of $4 trillion and S&P sticks to its words, after a brief muted market reaction, the direction of the markets will be highly leveraged to the data with expectations of a second-half rebound in economic activity hanging in the balance.”