The political leaders of the US may have played a somewhat unseemly game of political brinkmanship when it came to agreeing to raise the US federal governments borrowing limit early this week. But the deal got done and the world financial markets breathed a sigh of relief.
The US is clearly not out of the woods yet in terms of sustained economic recovery but perhaps one positive out of the whole debt ceiling debate was that it certainly put the issue of getting the US debt under control at the top of the political and national agenda, and the deal maps out a course over the next few years to get the debt level down to a manageable level.
As the world's largest economy, what happens in the US has a direct impact on the Australian market and investors.
Vanguard's chief economist in the US, Joe Davis, believes the US economy has hit a "pothole" - and a pretty serious one at that.
"It's the debt concerns in the United States, Europe, and others that are very serious in nature, and so ultimately, a pothole, I think, is symbolic of the fact that we have a probability of a recession of about one in three, and in the early stages of recovery, you don't want to be talking about the probability of recession. We had those odds this time last year and, fortunately, we weathered the storm. I think, though, those odds are a little bit more serious, in part because of the potential tail risk that we could face with respect to the sovereign debt concerns," Davis says.
"More likely than not, we will see a modest acceleration in growth through the next several months, but the uncertainty over the landscape has increased at a point which we would have hoped this time six months ago it would have decreased. So it's just again a reminder that many of the headwinds we will face are secular in nature with respect to housing, consumer debt payoff, and structural deficits."
In the short-term, the risk remains that credit rating agencies such as Standard & Poor's or Moody's could downgrade the rating of U.S. debt (Treasury securities), and that could see another short-term spike in volatility.
A downgrade would be a sign of waning confidence in US elected officials' ability to craft and deliver a long-term debt strategy. The compromise reached this week looks like a good start but much of the detail around spending cuts is to be worked out. Once a satisfactory plan is in place, markets would be expected to return to normal, and investors would focus once more on fundamental issues like long-term earnings growth and the overall economic health of the U.S. and other countries.
That said, it's simply not possible to gauge precisely how the equity and fixed income markets would react-and for how long. That's why the best course of action is probably to tune out the ever-changing headlines and political rhetoric, and maintain a long-term focus. If your personal financial goals and time frame haven't changed, neither should your long-term investment strategy.
When it comes to understanding the impact of any ratings downgrade, it is nearly impossible to predict the impact of a downgrade with certainty because it is unclear how investors in the fixed income markets will react. We may see US Treasury prices fall if investors pull back from that segment of the market. On the other hand, a downgrade could have the opposite effect, causing a "flight to quality" which would see US Treasury prices rise. If U.S. debt is downgraded, the corporate bond market could experience an increase in volatility in certain sectors, such as financials. However it is likely any volatility will be short-term in nature as policymakers would be under pressure to find a resolution in short order.
What should investors do? "Wait and see" may not be the most satisfying answer to this question, but it's probably the right one.
The last thing any investor should do in response to this situation-or any period of volatility and uncertainty-is to overreact. Long-term investors who have stuck with their strategic plans through previous bouts of market jitters know it's probably a mistake to base major investment decisions on the latest headlines.
With a $15 trillion gross domestic product, the U.S. boasts what is by far the most productive, stable, and diversified economy in the world. The U.S. dollar remains the world's primary reserve currency. And U.S. financial markets have a track record of remarkable resilience. All of these advantages will remain in place regardless of events in the nation's capital.
22nd-August-2011 | 
