Equity markets got hammered yesterday as investors weighed the implications of Standard & Poor’s downgrade to U.S. long-term debt.  The S&P declined 6.7% and volatility spiked 50% to the highest level since March 2009.

According to Bloomberg, yesterday’s rout erased $2.5 trillion in global equity values and sent 25 countries into bear markets including China, the U.K., France, Germany, Spain, Italy, Switzerland, Brazil, Russia, and India.

Treasurys rallied despite S&P’s downgrade to U.S. long-term debt, a sign the market still views the U.S. debt a safe haven – something that our Senior Fixed Income Analyst touched on in his letter yesterday.

S&P is justified in its decision because U.S. politicians did, in fact, flirt with the idea of default and thus the issue of willingness to pay should be considered.  The country’s ability to pay its debts, however, remains unquestioned – the size of  the economy, wealth of its inhabitants, and assets of the government are easily sufficient to repay the $14 trillion in debt (much of which is owed to itself) plus interest.  The U.S. also controls the printing press for the world’s reserve currency, which allows the U.S. to monetize its own debt.

S&P’s actions didn’t give us any new information, but what was all the fuss about in the market?  

Market Activity for August 8, 2011

Sector Activity for August 8, 2011

S&P Gets the Headlines, But the Economy Is the Real Concern

S&P was the media star yesterday, but the real concern is that the economy seems to have very little momentum going into the second half of the year.  Recent figures show the U.S. on the brink of recession –consumers are tapped out and may not be a relevant force until the labor market improves, which is a long ways off.  Meanwhile, manufacturing data is signaling a slowdown and the anemic housing market shows little prospect for improvement.

QE3 may very well be coming.  I did not believe this was ever a real possibility, maybe in part because of the lack of positive impact QE2 had on the economy, even if it did give the stock market a shot in the arm last year.  But with the government unable to provide fiscal stimulus and interest rates already at zero, the Fed may feel they have no choice but to engage in another round of quantitative easing.

Today the Federal Open Market Committee’s monetary policy meeting concludes and is likely to get a lot of attention as traders look for any hints that may suggest more easing is ahead.

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Have a great day!

Peter Lazaroff, Investment Analyst

Phone: 636-449-4900