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“S&P’s U.S. downgrade adds further fuel to a red-hot political debate”, says Skandia Investment Group’s head of asset allocation Rupert Watson

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Credit rating agency S&P has downgraded the outlook for US long term debt from stable to negative. They said there was a 1 in 3 chance that this would lead to downgrade of US debt from its current AAA-rating within 2 years. S&P’s Nikola Swann says: "More than two years after the beginning of the recent crisis US policymakers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures."

There is currently an intense debate in Washington over what steps should be taken to reduce the deficit and over what timescale. As well as being a huge political issue now, it is likely to be one of the central issues in the 2012 Presidential and Congressional elections. This move by S&P will raise temperatures even further.

Global equities weakened significantly on the news, while gold rose to a new record. Moves in other asset classes were more muted, with bonds only slightly weaker and the US$ little changed versus a basket of currencies.

In the short to medium term, the move by S&P is likely to generate a lot of political heat and noise. The market implications – in terms of equities, bonds and the US$ – may be more muted. It is surely of no surprise to anyone that the US fiscal position is materially worse than it was a few years ago. S&P’s move adds some urgency to the debate, but outside the political issues, little else.

Some will argue that if the US were to be downgraded some overseas investors would be forced to sell their US government bonds and re-invest in other AAA-rated sovereign bonds, leading to US$ and US bond weakness. It is not clear how significant this would be since there are few other AAA-rated sovereigns left (UK, France, Germany, Australia and a few others). The broad stability of both the US$ and US bonds today supports this view.

In summary, the S&Ps move to downgrade the US outlook will add further fuel to an already red-hot domestic political debate. At the margin it could make more aggressive and earlier cuts likely, although significant fiscal tightening still remains unlikely until after the elections at the end of 2012. The market reaction – after the dust has settled over the next few days – is likely to be more muted.

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