The Credit Downgrade: Answers To Your Questions

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OCEAN CITY — In the first of a two-part series, Lisa Shalett, Chief Investment Officer of Merrill Lynch Global Wealth Management, explains Standard & Poor’s decision to downgrade U.S. government debt, puts recent market volatility into perspective, and suggests steps investors should consider taking now to safeguard their investments.

The decision by Standard & Poor’s to downgrade U.S. government debt one notch — from AAA to AA+ — probably couldn’t have come at a less favorable moment, occurring at the end of a week that had already seen an eleventh-hour resolution of the U.S. debt-ceiling impasse, a market reaction to concerns that the financial crisis in Europe could be spreading to Spain and Italy, and a tumultuous drop in the Dow.
Here, Shalett answers some key questions:

(BOLD)What does a ‘downgrade to the U.S. debt’ really mean? And why is it considered so important?
In downgrading the credit rating of the U.S. government from "AAA" to "AA+," Standard & Poor’s — one of the world’s three major debt-rating agencies — has removed the United States from its most elite list of borrowers for the first time in the nation’s history. Theoretically, this could raise the price the country will have to pay creditors to fund its debts. In the statement accompanying the downgrade, S&P said that a major factor in its decision was its disappointment with the political process in Washington over the recent debt-ceiling impasse, and its growing skepticism that policy makers in the current political environment can reduce the ratio of the nation’s debt as a percentage of its gross domestic product to more manageable levels.

What did S&P mean by "negative outlook"? And does that mean further downgrades are possible?
The S&P’s rating downgrade specifically applies to what it calls the country’s "medium-term debt dynamics." But in the same statement it also issued a "negative outlook" for the country’s longer-term fiscal prospects. The implication was that the agency would wait to see how the new Special Bipartisan Committee created by the debt-ceiling legislation carries out its deficit-reduction mandate, and how the process continues to play out through the 2012 election, before making further decisions about the country’s credit-worthiness.

How significant is it that other rating agencies haven’t lowered their ratings? 
Very. Moody’s and Fitch issued their own reports re-affirming their top ratings for the U.S. – of Aaa and AAA respectively. This technically leaves the U.S. with a "split rating," which means that institutional investors — some of which are required to hold a certain percentage of their assets in the highest-rated securities — almost certainly won’t be forced to reduce their Treasury holdings.

In your opinion, how will the downgrade likely affect the stock market in the coming days and weeks? 
The S&P ratings downgrade is historic and unprecedented, and market psychology is fragile after all the volatility we’ve seen. But, we’re actually much more concerned about the outlook for global GDP growth and the Eurozone debt situation, though even there we have seen some positive signs in recent days. Chiefly, we’ve been encouraged by the European Central Bank’s announcement that it will aggressively start buying Italian and Spanish bonds, and the strong statements by the G7 nations about the steps they’re willing to take to bolster those efforts. We have also become more optimistic that the U.S. Federal Reserve may eventually consider additional quantitative easing measures.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)

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