Will the US lose its AAA rating?

With significant media focus on the recent debate about the United States debt ceiling, there are many reasons for investors to feel nervous. However, we believe this is a short-term problem.

What is more concerning is what happens if the US, the “risk-free” benchmark from which all other assets in the financial market are priced, loses its coveted AAA rating? The heated debate about the US debt ceiling has sparked some of the rating agencies like Moody’s and Standard & Poor’s to issue a warning to the US that it may downgrade its AAA rating to AA if a decision on lifting the debt ceiling is not finalised in the near future.

If the unthinkable happens and the US loses its AAA rating, the psychological repercussions could be serious. This could set the stage for further deterioration in the markets, which may have a longer lasting effect.

One example of a severe repercussion is in US treasuries. With some countries, including China, having their currencies pegged to the US dollar, a certain amount of US treasuries need to be purchased in order to enable the currency to be pegged and maintain stability. This “safe haven” mentality will vanish and there will be major instability in global trade and currencies around the world.

Our view is that this will not occur in the foreseeable future, particularly as there is currently no reliable alternative. However, to even contemplate the downgrade, means that while the probability is low, it is not impossible.

Upcoming profit season

Investors know that the long-term driver for growth in sharemarkets is profit growth. Therefore with markets fluctuating over the past 18 months, we look to the upcoming reporting season in both the United States from mid July and Australia from mid August, to provide us with a better understanding of what is transpiring in the corporate world.

As financial markets are forward-looking mechanisms and prices discount the expectations of investors in the future, we can examine the outlook of a particular company, sector or overall economy based on the statements by corporate executives.

With recent macro-economic fears and natural disasters disrupting supply chains, some analysts are now questioning whether this reporting season will contain a more subdued outlook, given the already weak consumer spending and sentiment.

There are several important factors that investors will be anticipating, which may affect the general mood of sharemarket participants, including:

• profit margins and whether labour and rising commodity/input costs have had a detrimental
  impact on their net profit;
• how the banking sector is dealing with low credit growth;
• trends in consumer sentiment in light of the headline troubles in Europe; and
• the clarity and confidence in which corporate executives describe their company’s outlook.

If we receive positive news regarding these points, markets will more than likely increase. However, if not, brace yourselves for continued choppiness.