What if S&P’s wake-up call works?


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Money managers worry that tough deficit cutting could derail nation’s fragile recovery

By Jeff Benjamin

Notwithstanding ho-hum reactions from bond professionals and helter-skelter movement in the stock market, last week’s negative outlook for the triple-A debt rating of the United States by Standard & Poor’s prompted investment professionals to wonder: What will happen if Washington starts dealing with the nation’s ballooning $14 trillion debt?
“The national mood right now is one where people are expecting Washington to start dealing with the debt, and this [credit-rating announcement] is an opportunity for the president and Congress to take some action,” said Robert Tipp, chief investment strategist of fixed income at Prudential Financial Inc., which manages $270 billion in fixed-income assets.

The S&P report, which included a one-in-three chance that the ratings agency will downgrade U.S. debt in the next two years, helped push gold prices to new records and acted as a tipping point for the equity markets, which already were bracing for a rough start to the day following negative news from Europe.

Most advisers shrugged off the initial market volatility that pushed stocks down more than 1% on Monday — and some even saw it as a temporary buying opportunity — but the real challenge is in analyzing the longer-term impact of the S&P announcement.

“Hopefully, this will help to convince Washington to attack the deficit,” said George Wolfson, chief fixed-income strategist at Sym Financial Advisors, which has more than $800 million under advisement.

Like many advisers and money managers, Mr. Wolfson described the S&P announcement itself as a “big non-event” because most people know that the U.S. government is building record deficit and debt levels.

But if the increased attention on the management of the federal budget leads to a realistic plan to reduce the country’s debt levels, the economy and the markets will take a hit, market watchers said.

“The warning of a downgrade is the proverbial shot across the bow to Congress, but the long-term implications here are growth-negative because doing something means either fiscal austerity and/or higher taxes,” said Michael Mata, who helps manage $24 billion in fixed-income assets at ING Investment Management Co.

The bottom line is, fiscal austerity applied to such a fragile economy would not be pretty, which is what advisers and money managers are taking into account.

It also helps justify a Treasury market rally last week on the news that Treasuries were being identified for a potential downgrade.

On Tuesday, Treasury Secretary Timothy Geithner said there is no risk the United States could lose its top-tier triple-A credit rating, especially as politicians move closer to agreeing on how to slash the massive U.S. debt.

“If you’re of the belief that people in Washington will take the message and do something, that means economic growth in the near term slows and the Federal Reserve stays on the sidelines even longer,” keeping short-term interest rates near zero, said Tom Girard, head of the fixed-income group at New York Life Investment Management LLC, where he oversees $134 billion in fixed-income assets.

While Mr. Girard isn’t completely ruling out the possibility of the United States’ being placed on a credit watch list, which has never happened, he said investors also should be prepared for the fallout of a “credible plan that takes a meaningful bite out of the deficit.”

“This could change the outlook from the economy growing at 3.5% next year with a Fed rate hike to 2.5% growth and no rate hike,” he added.

Beyond the latest dust cloud kicked up by the S&P announcement, the economy and the markets also are seen as at the mercy of the continuing debate over raising the nation’s debt ceiling, which limits the amount of money the U.S. can borrow, as well as the pending expiration of the second round of quantitative easing, during which the federal government bought $600 billion worth of Treasuries.

“The S&P announcement is a step in the right direction that should have happened sooner, but we’re more interested in what’s going to happen over the next 30 days,” said Theodore Feight, president of Creative Financial Design.

As the debt ceiling issue and the expiration of QE2 draw nearer, Mr. Feight has built up cash positions of between 10% and 15% in clients’ accounts.

And if the debt ceiling is not raised, he said, he will adjust equity position stop-losses from a 25% decline to around 15% in response to increased stock market risk.

As market outlooks go, the convergence of political and economic events is testing the limits of a 30-year bull market in Treasuries.

“In the short run, there is almost evidence of a bubble market in Treasuries, but over the next six months, after the removal of QE2, I think Treasury rates will go up,” said David Kelly, chief market strategist at J.P. Morgan Funds.

But the 10-year Treasury, which peaked at 15.84% in September 1981 and is currently at 3.4%, is still the darling of advisers such as Paul Schatz, president of Heritage Capital LLC, which has $104 million under advisement.

“QE2’s impact on Treasuries was anything but robust, so I’m not worrying about it going away,” he said. “And we’re out of painless fiscal solutions from Washington. I’m not worried about Treasuries and won’t get worried until the 10-year yield gets to 4.25% or 4.5%.”



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