Markets have been trading for two sessions now since the US was downgraded by S&P. While the net effect is a decline in stock prices and bond yields (bond prices higher), markets shot ahead today after the US Fed committed to keep interests rates low until at least mid-2013. Volatility has been stunning with vicious price movements in both directions in both stocks and bonds.

US Downgrade

• The potential for a downgrade was telegraphed to the market last month.
• There are three agencies that rate US debt. Moody’s and Fitch have reiterated their top ranking.
• S&P downgraded long-term debt one “mini-notch“ to AA+.
• The qualitative difference between the two ratings is virtually imperceptible.
• There are however, psychological and technical issues that come from this.
• Short term money market securities retain their top ranking. This is helpful, money market funds will not be forced to sell.
• Bank capital will also not be impacted as a result of the downgrade another helpful detail.
• We do not expect forced selling by institutional holders such as pension funds as a result of this.
• S&P has now begun the process of downgrading a host of other entities such as municipal governments, government sponsored entities and corporations as well.
• Long term impacts of this are unknown, however, the path of borrowing costs will be primarily driven by economic growth.

Stock market reaction

• The immediate reactions was more panic Monday with most world stock markets off 4-6%. Tuesday’s action saw a significant rebound with stocks regaining 4-5% of the drop.
• We expect today’s positive tone to be carried through in the Asian & European trading sessions overnight.
• Volatility is very high and should be expected to stay that way until a more complete picture on the economic front becomes evident over the next few months.
• Stocks are now deeply oversold reflecting the panic selling.
• Stocks remain vulnerable to headlines.

Bond market reaction

• Government Bond yields fell (this is a good thing for bond holders as it means prices rose) significantly. This is counterintuitive – if the real issue was lower US credit quality, yields would rise.
• Bonds are reacting to the panic and are playing a safe haven role.
• The volatility in bond prices is also very high.
• Canadian Government 10 year bond yields now sit at roughly 2.4%.
• Canadian Government bonds hit an all time low today of 2.3% intraday.
• Corporate bond spreads have begun to widen but remain well behaved.

European situation

• The European Central Bank has been buying Italian and Spanish bonds in the marketplace.
• This action has caused Spanish yields to fall over 1% and Italian yields to fall just shy of 1%
• This is a huge decline and is a very welcome reduction in funding costs.
• More buying is required.

FED action today

• The US Federal Reserve changed the wording of its policy (remember rates are already pretty much as low as they go) to extend out into the future (at least mid 2013) any potential for rate hikes.
• This is intended to keep short term rates low and encourage investors to take risks without the Fed actually buying any new securities and adding to the size of its balance sheet.
• The Bank of Canada used a similar tactic in 2009, however over a shorter time frame.
• They also reiterated their commitment to use all policy tools available to them should growth disappoint.
• No commitment to buy more assets (QE3 would be the term used) was made.
• Market volatility in the wake of this announcement picked up, however stocks ended up sharply.

Implications for strategy

• With long term inflation expectations around 2-3%, an investor buying a 10 year bond today and locking in 2.4% for 10 years will be losing money, not even considering tax.
• Good quality equities and corporate bonds are the best bet for protecting capital from inflation and providing for capital growth.
• Buying companies with strong balance sheets that are growing yields to investors will be rewarded.
• The price of this for investors is putting up with the volatility over the shorter term.

Actions

• We feel current prices are discounting a lot of bad news and have begun to add stocks. This will be a staged process and we will reassess as new information comes in.
• Our first move is to buy Emerging Markets stocks which have sold off particularly hard.
• This region will continue to be the engine of the worlds growth and this represents a good entry point for positions.
• Bond duration has been shortened to protect capital in the event of a rise  in yields.

I would like to thank the analyst team at Connor Clark & Lunn Private Capital for their timely insights during these economic times.