S&P got it wrong, economy will avoid second recession: Buffett

For those of you joining in late, here’s the story so far: Late on Friday (US time), capping a week in which global equity markets lost more than $2.5 trillion in value,ratings agency Standard and Poor’s downgraded the US’ prized long-term sovereign AAA rating to AA+ on concerns over the nation’s fiscal deficits, and the political brinkmanship that surrounded the deal agreed by Congress to raise the debt ceiling. The move further soured investment sentiment, already damaged by growing fears of a stalled recovery in the US and a snowballing sovereign debt crisis in Europe.

The ratings firm’s action immediately came in for some severe criticism from the White House, which pointed out that the calculations of the S&P did not take into account deficits reductions from the recently-concluded deal of up to “$2 trillion”. Amazingly, the ratings firm acknowledged that it had made a mistake in its calculations, but stuck to its downgrade anyway, maintaining that the change was not “meaningful” enough to affect its rating decision.

The ratings agency said the growing debt-to-GDP ratio of the US, the increasingly hostile political environment in which public policy is being framed, and the fact that the recently-concluded deal on raising the debt ceiling contained nothing to encourage economic growth in the short run, were the main reasons for the downgrade.

Besides the US government, there were a few critics who thought the S&P had got it all wrong. Billionaire Warren Buffett was among them. While maintainingthat the economy would avoid its second recession in three years, he claimed that the US merited a “quadruple A” rating, in an interview with Betty Liu at Bloomberg Television.

Buffett, however, was among the minority. By and large, after the initial shock wore off, most market commentators believed that the S&P, while perhaps a little hasty in its decision to downgrade US debt, was not really far off the mark in its assessment of the current state of America’s policy-making process or of the nation’s fiscal trajectory.

As Tim Worstall, a Fellow at the Adam Smith Institute in London, noted on his blog on Forbes : “…the move in the rating is simply confirming what the market already believes and markets don’t move on old information, they move on new information.”

Meanwhile, even as all this drama unfolded, across the Atlantic, Europe continued to grapple with its own problems. A sell-off in Italian and Spanish debt last week prompted the European Central bank to announce that it would buy eurozone bonds. Italy and Spain have become the latest in a growing list of European countries that have been dogged by debt repayment worries.

In addition, in response to the market turmoil of the past week, the G-7 announced in a statement that it will take “all necessary measures to support financial stability and growth,” the nation’s finance ministers and central bankers said in a statement today. Members also agreed to inject liquidity and act against disorderly currency moves if necessary.

The ratings downgrade and Europe’s debt crisis will be on everyone’s minds this week. So how will markets react?

Money markets

The $2,700 billion industry is a key market for trading in US Treasuries (very short-term government paper) and provides short-term financing to banks and companies in the US and around the world. A rush of withdrawals in this market during the global financial crisis of 2008 is what led to the evaporation of liquidity from the financial system back then, said a Financial Times report.

S&P’s decision to maintain the US’ short-term rating at the top A-1+ level even as it cut the long-term grade from AAA is likely to stabilise money markets, according to a Bloomberg report .

Money market funds will not be forced to sell Treasuries and, therefore, the impact could be limited. Treasuries are pledged as collateral by borrowers in the $4 trillion repurchase market, where banks, companies and investors come together for short-term funding.

Watch former Obama aide Lawerence Summers lash out at S&P

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Equity markets

There are very diverse opinions on how stock markets will react in the short term, although most experts expect some volatility. Former Federal Reserve Chairman Alan Greenspan said he believes stocks will continue their decline after the S&P downgrade. “Considering the momentum in which the market went down over the last week, it is very unlikely, if history is any guide, that this isn’t going to take a while to bottom out,” Greenspan said. “So the initial reaction in my judgment is going to be negative.”

However, S&P’s managing director of sovereign ratings, David Beers, said he didn’t expect markets to react significantly. “Based on historical experience, we wouldn’t expect that much financial impact,” Beers said. “The markets are reacting to a lot of factors, not just what S&P said on Friday.”

At the moment, it looks like Greenspan might be right: Asian stocks dropped for a fifth day early Monday, extending the worst global slump since the bull market began in 2009. And most experts believe European and US markets will also trade lower when they open.

Societe Generale SA predicted “shock and already shaken confidence in an illiquid market. Brace for turmoil in next few days or weeks,” the French bank’s head of North American research, New York-based Stephen Gallagher, wrote in a note.

About $5.4 trillion in global equity value has been erased since 26 July, according to Bloomberg data, after Europe’s debt crisis worsened, and reports on US manufacturing and consumer spending showed the world’s largest economy was slowing. The ratings downgrade, while not a shock in itself, does nothing to ease investors’ nerves.

Gold and other commodities:

US gold futures and cash bullion struck records on Monday, with December contract hitting a record of around $1,698 an ounce. Cash gold touched a lifetime high around $1,689 an ounce before losing some of the gains. Silver tracked gold higher, platinum was steady, while palladium fell more than 3 percent in thin trade. Gold has gained 18 percent this year, and while it is expected to climb further, some profit-taking also can be expected.

Fears of a debt contagion spreading across Europe, and a stalled recovery in the US will keep interest high in the precious metal. Those same concerns, however, will keep investors away from other industrial commodities, such as copper.

Investors put $2.6 billion into commodity funds in the week ended 2 August, according to EPFR Global, a global funds-tracking company. Almost all of the money went into gold, and industrial-commodity funds had an outflow of $260 million, the firm said.

Metals have experienced a losing streak in recent days: Copper futures, for example, fell 2.8 percent on 5 August, capping the biggest weekly slump since June 2010. While fears of a recession continue to swirl, don’t expect metals to make a significant come back anytime soon - unless of course, Federal Reserve chairman Ben Bernanke decides to introduce another round of quantitative easing (QE3).

Bond markets:

JP Morgan Chase & Co. estimated that a downgrade would raise the nation’s borrowing costs by $100 billion a year. “It would likely increase Treasury yields by 60 basis points to 70 basis points over the “medium term,” the financial institution had said earlier.

Currently, continuing economic turmoil in other countries around the world is keeping yields at near-record lows, as investors continue to buy Treasuries as ‘safe havens’. When investors buy bonds, bond prices increase while yields fall.

Even amid talk of a ratings downgrade, the two-year Treasury note yield reached a record low of 0.25 percent last week. Rates on 10-year notes and 30-year bonds also plunged to their lowest levels of the year last week.

Regulators also said that S&P’s downgrade will not affect the capital positions of US banks. Banks, which hold Treasuries as a form of capital, won’t need to build larger cushions to protect against possible losses, a group of banking regulators, the Federal Reserve said late on 5 August. “For risk-based capital purposes, the risk weights for Treasury securitiesand other securities issued or guaranteed by the US government, government agencies and government-sponsored enterprises will not change,” the regulator said.

Yet, there are a large number of other Treasury owners, including insurance companies and pension funds, who are allowed to only own AAA assets. A ratings downgrade typically should force them to sell their current Treasury holdings and seek other AAA-rated assets. But since only S&P has downgraded the sovereign rating of the US; we are unlikely to witness any large-scale selling by Treasury holders. At the moment, Moody’s has not said that a downgrade is imminent. “As long as Fitch and Moody’s keep their AAA rating then technically the US is still rated AAA. S&P on its own changes pretty much nothing,” pointed out Tim Worstall.

Moreover, Standard & Poor’ssaid it would “issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors” on Monday. SocGen predicted likely downgrades of mortgage financiers Fannie Mae, Freddie Macand the Federal Home Loan banks as well as clearinghouses and “certain AAA rated insurers.”