Late Friday afternoon, August 5, 2011, when most people were off to Happy Hour, drowning their cares after a wild week of Dow Drops, Standard and Poor's dropped a bomb. The U.S. Credit Rating was downgraded from AAA to AA+. The U.S. is no longer on CreditWatch, but the Outlook is Negative, meaning that if Congress does not make the requested budget savings of at least $4 trillion as soon as possible, the U.S. credit rating could be downgraded again.
Below are FAQS and answers on the downgrade. Additionally, you'll find links to the White House, the House of Representatives and the Senate below, so that you can email your elected officials and encourage (demand) that they stop the politics and get America's fiscal house in order. Armed with the FAQs, you will be in a position to understand clearly that both sides of the aisle failed the American people.
1. What are "budget savings?"
The credit rating agencies take "no position on the mix of spending and revenue measures that Congress and the Administration might conclude is appropriate for putting the U.S.'s finances on a sustainable footing," according to both Moody's and Standard & Poor's. However, both agencies have been clear that the key to avoiding the downgrade was to implement $4 trillion in savings over the next ten years, which could be achieved from a mix of cuts and increased revenue -- provided the cuts and taxes/revenue would not damage GDP growth. I wrote extensively on this topic on July 27, 2011, in my article, "Debt Downgrade and Default: Uncovering the Bipartisan Truth." Read this article at HuffingtonPost.com/Natalie-Pace.
2. What happens now?
If Congress gets smart, goes back into negotiations immediately and comes up with a credible plan to implement budget savings of more than $4 trillion over the next 10 years, the world will have renewed faith in the world's largest economy. If they don't, GDP growth will slow, unemployment will remain high, interest rates will rise and companies that are linked closely to the U.S. government will also be downgraded, namely Fannie Mae, Freddie Mac, the 'AAA' rated Federal Home Loan Banks, and the 'AAA' rated Federal Farm Credit System Banks, the Army & Air Force Exchange Service, the Marine Corps Community Services, and the Navy Exchange Service Command. The stock market has already retreated, and the bond market could also retreat, further decimating the individual retirement plans of hundreds of millions of Americans, which have not fully recovered from the losses in the Great Recession.
3. Interest Rates.
The U.S. will now have to pay higher interest rates on its debt. That means that the Debt Ceiling Deal is now a joke. Achieving $4 trillion in budget savings will require even more spending cuts and revenue generating (taxes). Interest will become an even bigger slice of the spending in Washington, making it even more difficult to balance the budget.
4. Stock Market.
The S&P500 Index dropped 4.8% on August 4, 2011 (savvy investors were already anticipating the downgrade) and is down 12% since the high of April 29, 2011. Since the downgrade occurred after markets closed on Friday, there could be another slump when markets open on Monday, August 8, 2011. However, that does not necessarily predict a bear market. While the downgrade is bad news and the ramifications of the downgrade will be felt broadly and deeply in the months to come, that does not mean that selling your stocks on Monday is the best idea. (Keep reading this article to the end before you make your decisions.) If you bought into the NASDAQ when the markets opened after 9.11.01, your returns were, on average, 35% gains within four short months (by January 2002). If you sold, you locked in losses and sold low, when you could have made a much more profitable choice within a few short months.
The downgrade of the U.S. credit rating is sad and shocking, but it is a message to Washington to get America's fiscal house in order, not a death knell for the U.S. As Dr. Lawrence Yun, the chief economist at the National Association of Realtors reminds us, "Many big companies have huge cash reserves at this moment so the corporate [bond] rates may not move too much on the news." In fact, if the dollar weakens, exports could actually benefit. Many U.S. corporations are getting a significant portion of their revenue from other countries. So, 3rd quarter earnings could be better than you might expect, even if growth is dampened by the downgrade.
5. Bond Market.
The downgrade will be felt in the bond market -- particularly in Treasury bills. Rising interest rates (as a result of credit downgrades) decrease the value of existing bonds. The prices for financing a home will go up (unless the Feds print a lot more money). Dr. Yun is not worried that higher interest rates will weigh down the housing market. He's more concerned about underwriting standards, which in his view are "way too tight." A senior executive of a major investment bank in New York City told me that corporate bonds will be affected, but he doesn't anticipate a crash because bondholders are less emotional than stock owners.
The Federal Open Market Committee meets on Tuesday, August 9, 2011, and their response may be to print more money and buy it up themselves (Quantitative Easing III?). In that case, the excess cash in the system means inflation. Low risk, cash positive hard assets become desirable in that scenario.
The bottom line is that you need to check your bond portfolio with a forensic eye to credit risk, as well as inflation risk. There are two important articles on this topic in my May 2011 NataliePace.com ezine, volume 8, issue 5. Bonds are no longer safe across the board, and they can definitely lose principal value in today's world. (I began issuing bond alerts in 2009.)
6. Should You Sell Into a Slide?
Be very careful. You might think that getting your order in now will mean you are first in line, but executing a market order into a falling marketplace can be a disaster. If you are determined to sell on Monday, then consider placing a limit order, where you get to determine your sell price. It was a far more profitable idea to sell a few months after 9.11, than it was to try and stop losses when the markets opened on the 17th of September, 2011.
The savvy investor has a Stock Shopping List handy for market corrections like this. And that person is always in the best seat to buy low, instead of selling low, when the markets slide.
7. Will the Markets Fall to Zero?
No. Even if investors wanted to take the stock market to zero, they can't. There are mechanisms that halt trading if the markets fall too far, too fast. There are three circuit breaker thresholds -- 10%, 20%, and 30%. If there is a 10% (1200-point) drop in the Dow Jones Industrial Average before 2:00 p.m. ET, the market will stop trading for one-hour. If there is a 20% drop (2400-points) before 1:00 p.m., the market will stop for two hours. In the event of a 30% drop, regardless of the time, the market closes for the day. After 9.11, the stock market was closed all week, reopening on the following Monday, September 17, 2001.
Under a new pilot framework established by the SEC, FINRA and the stock exchanges, there is a 5-minute "pause" that is triggered when certain individual stocks fall by more than 10% in a 5-minute period.
8. How long will stocks take to recover?
The long-term recovery is highly correlated with GDP growth. If the U.S. economy starts growing again, stocks will rise. Before this debacle, the economy was predicted to have a relatively strong second half in terms of GDP growth, continuing into 2012 -- a positive sign. If consumers are disgusted with Congress and worried about the economy, they may stop spending, which impacts corporate sales and profitability, which slows GDP growth. This will be an ongoing story, which I will continue to report on in my Hot News on Cool Stocks reports, twice a month.
9. What should you do?
Contact your Congressman and the White House and demand that they come up with a bipartisan plan to implement more than $4 trillion in budget savings over the next 10-years, so that the U.S. can earn back its AAA rating and get back to the business of growing the economy and creating jobs. The politics must stop. Paying our bills, creating a sustainable plan for spending (including Medicare, Medical, Social Security and Defense -- the Big Four) and reforming the tax code is a bipartisan approach that is recommended by the most respected economists in the world.
10. Who's to blame?
According to Neil Cavuto (speaking on Cavuto on Business August 6, 2011), Senator Mitch McConnell said that he could have reached the $4 trillion mark if the Republicans had agreed to raise taxes, which he refused to do. There are widespread reports that the Obama Administration had agreed to support an increase in Medicare's eligibility age, to means-test certain Medicare programs, to cut Medicaid benefits and to restructure the payments of Social Security benefits as part of a grand bargain with Republicans, if there was also a plan to increase revenue. Majority Senate Leader Harry Reid bragged that the new Debt Ceiling Deal would not be making any cuts to the entitlement programs. Both parties congratulated themselves on the Debt Ceiling Deal and tried to promote the idea that the deal had "averted fiscal calamity," when in fact it had missed the $4 trillion in budget savings by almost $2 trillion. As we saw with the market drop on Thursday, Americans weren't buying that. As we saw on Friday with the Standard and Poor's downgrade, neither did the credit rating agencies.
I have a very important call-in radio show on Wednesday, August 10, 2011 at 9:00 a.m. PT (noon ET). I will provide another market update at that time, and you will also have the opportunity to get your questions answered. Call into: (347) 215-7305. Log onto: BlogTalkRadio.com/NataliePace.
About Natalie Pace:
Natalie Pace is the author of You Vs. Wall Street and the founder and CEO of the Women's Investment Network, LLC. She is a blogger on HuffingtonPost.com and a repeat guest on national television and radio shows such as Good Morning America, Fox News, CNBC, ABC-TV, Forbes.com, NPR and more. As a philanthropist, she has helped to raise more than two million for Los Angeles public schools and financial literacy. Follow her on Facebook.com/NWPace. For more information please visit NataliePace.com.