When Standard & Poor’s issued the first-ever downgrade on the credit rating of the United States on August 5 from AAA to AA+, it was only natural for investors to question how the decision might impact their portfolios, particularly bond portfolios. Ongoing market volatility and the looming threat of a European debt crisis further compounded the issue. Wealth spoke with Northern Trust Senior Vice President and Chief Investment Strategist Jim McDonald to help put the debt downgrade into perspective for investors.
What will the United States losing its AAA debt rating
mean for the financial markets in the short term vs. long
Jim McDonald: Our view ahead of the downgrade and subsequent to the downgrade continues to be that investors will not find any new information in the short-term downgrade of U.S. debt. The principal concern remains the long-term management of the U.S. deficit, and that is something that is probably not going to be resolved in next couple of years.
Should investors assume they need to reassess their
investment portfolios as a result of the
McDonald: The creditworthiness of the U.S. government hasn’t changed in the wake of the downgrade, so we wouldn’t recommend any portfolio shifts based on this. What the debt downgrade does introduce, however, is some increased risk that if S&P would apply this same process across the pond in Europe, it could be problematic for European sovereign credit issuers who are not as creditworthy as the United States. The implications are more secondary, raising the potential risk of other sovereign issuers.
How does the threat of the European sovereign debt
crisis play into this?
McDonald: The key developments that need to occur in Europe surround the willingness of the European Union to backstop the debt issued by the peripheral countries. We need to see progress in the Greek debt restructuring, as well as subsequent developments on supporting the European Financial Stability Fund, or EFSF. We need to see that there is support for that from the most creditworthy European countries — Germany, France and The Netherlands, for example.
What seems to be working in the market
McDonald: The Federal Reserve is signaling that they intend to keep short-term rates near zero for the next two years. We think that will benefit a strategy of moving out along the yield curve, not only in duration but also taking some credit risk. High-yield bonds, for example, are a great beneficiary of that circumstance.
But at the same time, we don’t want to counsel people to just sell their bonds. Bonds have proven to be the primary way to preserve capital in a difficult economic environment. The bond allocation always starts with the discussion about an investor’s risk appetite and their need for capital preservation. That doesn’t change based on what’s happened with the downgrade or from the Federal Reserve’s policy standpoint.
Rather than reassess a portfolio as a result of the debt
downgrade, what is a wiser strategy?
McDonald: The first thing an investor wants to do is set up his or her asset allocation based on what his or her expected liabilities are before starting to think about whether the markets are providing any particular opportunities based on either downgrades of the government’s rating or Federal Reserve policy.
The key issue investors need to address in their portfolios is: Do they have adequate liquidity to handle their financial obligations over the next several years, so they are never in position where they need to sell an asset to meet financial obligations at an inopportune time?
If you know you have several years of cash flow in your cash and short-term bond portfolios, you can be much more relaxed through market volatility. You are much less likely to have to sell stock when they are down and are more likely to be able to ride through the kind of volatility we experienced this summer.
That is a lesson that some of the most sophisticated endowments in the world failed to learn during the 2008 financial crisis. But it’s something personal investors can accomplish.
Should we expect continued volatility in the
I would expect the markets to remain volatile during the next 12 to 24 months as we continue to work through this period of slow economic growth and high government deficits, and as Europe works through their policy to deal with their troubled sovereign credit. That’s another reason to be especially focused on making sure your asset allocation gives you adequate liquidity to be able to weather the challenges that we continue to face in this post-financial crisis investing environment.
How will cash investments be affected?
The prospects for return of capital in cash look great. The prospects for a return on that capital are very low. The Fed will keep rates near zero for a couple of years, so you hold cash today and you don’t have to sell other assets to meet your cash flow needs during the next year or two. You are not holding cash to get an attractive return on it. The takeaway is cash allows you to keep the rest of your asset allocation in tact.
What chief concerns or questions are you hearing from
The number one concern that has been widespread among our investor base has been a worry that the Fed is going to print a lot of money, which will lead to a jump in interest rates. We don’t think that is a likely scenario. We think that slow economic growth and contained inflation means interest rates are not going to leap higher during the next couple of years. Therefore, you don’t want to significantly reduce your bond holdings because of that fear. You want to keep the amount of bonds in place to give you that comfort about the preservation of capital because if the equity markets decline and if we do go into a recession, your primary way to preserve capital in an equity bear market will be investment-grade bonds.
Jim McDonald is senior vice president and chief investment strategist for Northern Trust. In addition, he chairs the Tactical Asset Allocation Committee, is a member of the Investment Policy and Private Equity Investment Committees and is trustee of the Northern Trust Alpha Strategies Hedge Fund. He received a bachelor’s degree from the University of Michigan and master’s degree with high distinction from Babson College in Wellesley, Massachusetts. He is a member of the CFA Society of Chicago and a registered CPA in the State of Michigan.