How Markets Have Responded to Past Sovereign Downgrades

For more on the ramifications of the downgrade of U.S. debt, see my follow-up post Implications of the S&P Downgrade.
As is usual with crises, there have been no shortages of talking heads making predictions about what Standard & Poor's downgrade will mean. And as usual, the best you can do is look to history as a guide for what we may see.

Perhaps one of the issues prompting such clarion calls has been the reaction of Israel's market to the news. On Sunday, Israel's benchmark stock index fell more than 6 percent at its opening. The open of trading in Israel had been delayed by an hour after circuit breakers went into effect as the opening auction indicated a 5 percent decline. The market stabilized, though it didn't recover. Every stock in the TA-25 Index fell in the biggest decline since November 2008.

Of course, it's always important to look deeper at potential reasons for such a decline. Before one places too much emphasis on this drop, it's important to understand that Israel's market had been closed since before the U.S. market opened on August 3, when it fell about 5 percent. So, much of the loss was simply catching up to what had already happened around the globe.

Historical Market Returns So let's look at how other markets have fared in light of downgrades. When Canada lost its AAA rating in April 1993, the country's stocks gained more than 15 percent in the subsequent year, and the Tokyo stock market climbed more than 25 percent in the 12 months after Moody's downgraded Japan in November 1998. Also, if a high-grade sovereign debt rating is necessary for appealing equity market returns, how do we explain the last 10 years in Indonesia, where annualized returns have been 29 percent in local terms and 33 percent in dollar terms?

We can also use historical happenings to see how the bond markets have reacted. Historically, going from AAA to AA+ or even AA has had little impact on cost of a country's debt. For example, when Japan lost its AAA rating, there was almost no permanent effect. And the same can be said about Canada. It's only if the rating falls below AA that it becomes a big problem.

In addition, we can be pretty confident the market anticipated the likelihood of a downgrade. For example, I recently checked the yield on the short-term debt of Microsoft (MSFT), one of the four remaining AAA-rated companies -- along with Johnson & Johnson (JNJ), Automatic Data Processing (ADP) and Exxon Mobil (XOM). It was yielding about 0.3 percent more than the yield on the comparable Treasury. That's indicative of the AAA to Treasury spread. The credit-default swap market has also been pricing Treasury debt below AAA levels.

Possible Implications However, we must still be realistic. Things will likely change in light of the downgrade. Here are some potential ways the bond markets will be affected.

Municipal Bonds Many municipalities and several states -- such as Maryland, New Mexico, South Carolina, Tennessee and Virginia -- may see their credit ratings downgraded because of the relatively large share of Federal spending in their areas. And prerefunded bonds backed by Treasuries should obviously be downgraded one notch.

Mortgage Markets The downgrading of Treasury debt should certainly impact the debt of government agencies as well. We can include Fannie Mae and Freddie Mac in the same category as their debts have been guaranteed by the government. And S&P just announced that they had in fact downgraded their debt. Thus, it is possible that mortgage rates will rise, though this is far from certain. If that would occur, it would create a drag on economic activity and exacerbate the already difficult problems facing the housing market.

While the markets may still see adverse effects of the downgrade, it's important to note that there's still plenty of good news out there regarding the markets. Also, crises can "sow the seeds of their own ending," meaning such action could force politicians and other involved to step up and correct the problems that created this mess.

Italy provides us with a perfect example. Faced with sharply rising yields on Italian debt, Italian Premier Silvio Berlusconi announced Friday that Italy would be moving toward a balanced-budget amendment. This was what was required of Italy (large structural changes) if it wanted to obtain the support of the European Central Bank, which indicated that if Italy took tough action it would consider buying Italian and Spanish bonds. And late Sunday night the ECB announced that they would use the European Financial Stability Facility, their joint bailout fund, to buy Italian and Spanish government bonds on the secondary market (in an effort to hold down yields on them).

Berlusconi also announced plans for reforming labor laws and accelerating austerity measures. In other words, the market dictated that Italy had to act, or the rising cost of its debt would overwhelm the country's ability to pay. The result, a rally this morning in Spanish and Italian bonds.

Before you rush to make changes to your portfolio based on the news of the weekend, make sure you're not just reacting to noise. If you discovered you were taking more risk than you can handle, adjust your plan immediately. If you don't have a plan, create one, and remember how you felt this weekend to make sure you're taking the appropriate amount of risk.

Photo courtesy of Katrina.Tuliao on Flickr.
More on MoneyWatch:
Why the Stock Market Is Behaving Badly Don't Panic: Stock Market Crises Are Normal Stocks Plunge: Why It's Too Late to Sell Treasuries Surge Upon S&P Downgrade S&P Downgrade: Impact 'Should Not Be Significant'
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