Standard & Poor’s downgrade of the US debt rating and increased tension in the Eurozone debt crisis have significantly increased downside risks and the probability of a bigger market correction in the near term. The downgrade, while not unexpected and subject to extra scrutiny because of an initial calculation error, amplifies already rising sovereign risk concerns in Europe. In fact, as our strategists argue below, the impact of the downgrade may be more acute in Europe than in the US by bringing the “end game” forward. Those risks are a further headwind to a slowing global economy, one that’s likely to be buffeted by more fiscal tightening in 2012 brought on by the debt crises. With investors in de-risking mode and confidence fragile, failure to provide a more globally coordinated policy response could prove to be a tipping point for the markets, even though a recession is not our base case for next year.
Expect more volatility, while risk free assets are likely to benefit as risky assets come under additional stress. A paradoxical consequence of the rating downgrade is that Treasuries and the USD are likely to rally, at least in the near term, as investors assess the consequences of these latest developments. The same should be true for safe haven currencies (JPY and CHF), as well as some “true” AAA assets in the securitized product space that are not linked to Treasuries. Even if a more significant policy response is forthcoming, such as the European Central Bank (ECB) purchasing Italy sovereign bonds through the Securities Market Programme (SMP) to buy time to ratchet up the European Financial Stability Facility (EFSF) mechanism, investor skepticism about the efficacy of such efforts is likely to limit the near-term upside for risky assets from current levels.
Commentary is from the Morgan Stanley conference call: Eurozone Debt Crisis and US Ratings Downgrade, on Sunday August 7, 4pm (EST) / 9pm (UK) / 10pm (CET). Replay details below.
US Tollfree: 1 855 859 2056
International: +1 404 537 3406
Conference IDno.: 90310980
Replay available for 14 days starting from August 7, 7:30pm EST