Portfolio

What the downgrade means for investors

AARATI KRISHNAN | Updated on August 13, 2011

Nothing may change overnight, but the downgrade may eventually lead to stronger currencies and more fund flows for emerging markets.

When everyone predicts that an event will happen, can the actual event trigger market mayhem? That's the question that everyone in the stock, bond and currency markets is going to be worrying about this weekend, after Standard & Poor's downgraded its rating on long-term US debt from AAA to AA+, after market close.

The move itself was not wholly unexpected. Murmurs about the US losing its top credit rating have been getting louder ever since the 2008 credit crisis. The S&P had, in fact, put the US government on notice several months ago about a possible downgrade if it didn't take the spending cuts necessary to resolve its debt problem. However, the implications of this move are still so far-reaching that it may yet create a fresh bout of turmoil across stock, bond and currency markets on Monday.

What's the alternative

The immediate conclusion to draw from this is that investors, fund managers and central banks across the world that have all been parking money in US government treasuries in a ‘flight to quality', will now have to look for other ‘safe havens'. While that much is obvious, whether they can do this in practice, when they do it and where they take that money, are crucial questions that will decide the direction of different markets over the medium term. Even if most investors realise the precarious position of the US fisc, the truth is that they have not been able to find viable alternatives to US treasuries or the dollar in recent years.

That's why inflows into US markets actually increased in the aftermath of almost every recent crisis — the Lehman collapse, US housing collapse, the European debt crisis. Asset managers claim that US treasuries have remained the ‘safe haven' choice for them simply because no other global market is large enough and liquid enough to absorb all this money. And liquidity is a greater priority than returns in a crisis situation. Then there is the fact the US is home to a large chunk of the global investment surpluses in the first place.

Right now, global asset managers who would like to diversify away from the dollar have only a few choices. The Euro looks none too appealing after the string of debt problems in European nations. The Japanese Yen and the Swiss Franc, though they rest on stronger ground, may not have the wherewithal to absorb a flood of liquidity from overseas. Both the nations have in fact had their central banks trying to restrain currency appreciation in recent times.

To emerging markets

This doesn't mean that the debt downgrade will fail to spark any reaction from investors. Over the medium term, returns rather than capital safety will take priority and that will prompt these investors to allocate new money into other options. Evidence of this is already available from US pension funds such as CALPERS allocating more money into new options such as emerging market bonds and private equity investments in recent times.

In fact, the crisis enveloping the developed world may force global money managers to take a hard re-look at the emerging markets, where both stocks and bonds appear to be far better bets. It is high inflation and slowing growth, not the very safety of capital, that these markets are grappling with.

The likelihood of a weaker dollar over the medium term may also allow emerging market currencies to appreciate, adding a possible ‘kicker' to returns for foreign investors. On the equity side too, the likely spike in borrowing costs in US argues for higher allocations to other markets.

Domestic themes may win

As the Indian markets digest these factors starting Monday, there may be many implications for investors. In stocks, this may unleash a renewed scramble for companies and stocks that rely mainly on domestic themes such as infrastructure or consumption for their sales and profits. Companies with a large overseas leg to their operations, or those whose revenues are pegged to the dollar may be avoided. That means a near-term switch away from sectors such as IT, textiles and gems and jewellery.

In the immediate aftermath of this turmoil, though, there is just one asset that investors may rush to place their bets on. That is precious metals, led by gold. One would normally hesitate to bet on any investment that has had a tearing run over five years and hovers at a lifetime high. But after last week's events, investors may choose to make a beeline for tried and tested options. Nothing else may work for a while.

Published on August 06, 2011

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