July 27, 2021

Fundamentally: Credit Downgrades Can Be Poor Predictors — Fundamentally

THOUGH Wall Street is worried that the European debt crisis will worsen, the stock market barely budged when Standard Poor’s downgraded the credit ratings of several euro zone nations — in the process stripping France, Austria and the euro zone’s primary rescue fund of their AAA standing.

In fact, the Morgan Stanley Capital International Europe index and the Standard Poor’s 500 index of domestic stocks both rose in the days immediately after the news.

Surprised? Don’t be. Historically, credit downgrades have been a lousy predictor of stock market performance.

When Moody’s downgraded Japan in November 1998, for example, Japanese shares surged by more than 26 percent in the subsequent 12 months. When Canada lost its AAA credit rating in 1992, its equities gained 30 percent in the next year. And since the United States was taken down a notch by S. P. last August, the S. P. 500 has gained more than 9 percent.

This is not to say credit downgrades are a buy signal. It’s just that analysts at the major rating agencies are reacting to the same news and information that the rest of the market has already seen. So downgrades are really a lagging indicator, says Jeffrey Kleintop, chief market strategist at LPL Financial.

“With little move in the stock or bond market on the news of the downgrades, it is clear that markets had already made the credit adjustments and are now recognizing improvement” in the region, he says.

MARKET watchers note that while the rating agencies’ views carry weight, they merely represent one opinion among many on Wall Street. “I don’t see why their voices should be louder than the rest of the voices in the wilderness,” says James W. Paulsen, chief investment strategist at Wells Capital Management.

Indeed, when S. P. downgraded United States’ credit rating last year to AA+ from AAA, conventional wisdom said the move should make investors wary of Treasury debt, which in turn would push up the yield on 10-year Treasuries. Yet since the downgrade was announced on Aug. 5, the yield on 10-year Treasuries has actually fallen to 2.03 percent from 2.56 percent, a sign that global investors still view United States government debt as a haven.

Mr. Paulsen likens downgrades to interest rate moves by the Federal Reserve. “By the time the Fed officially raises rates, the market will have fully discounted it,” he says.

So instead of taking cues from the rating agencies, how should investors try to gauge the European crisis?

Mr. Paulsen says he prefers to rely on market indicators to judge whether angst over Europe is growing or shrinking. Among them are the performance of cyclical sectors of the economy versus defensive ones, and the so-called junk spread — the difference in yields between risky high-yield bonds and safe Treasuries. Both indicators speak to the level of fear in the market.

Since last summer, the consumer discretionary sector (companies that make things households want, not need) has returned more than 13 percent, versus 8 percent for the more conservative consumer-staples sector. At the same time, the junk spread has narrowed modestly, which speaks to a growing sense in the market that even if Europe slips into recession, its effect on the domestic recovery will be modest.

Robert C. Doll, chief equity strategist at the investment manager BlackRock, says the simplest thing that investors can do is pay attention to European bond yields, especially those for debt issued by troubled nations like Italy.

On the day S. P. downgraded Italy by two notches, to BBB+ from A, 10-year Italian bonds were paying 6.64 percent. Today, it’s 6. 34 percent.

Simon Hallett, chief investment officer at the asset management firm Harding Loevner, says the real issue “is about the health of companies in the region, not the health of the countries.”

And, on that count, the consensus among market analysts is reasonably positive. Despite growing fears that several countries in that region are in or near a recession, companies in the S. P. 350 Europe index are still expected to enjoy earnings growth of nearly 10 percent this year, says Christine Short, senior manager at S. P. Capital IQ .

Not only is that up from the 1 percent overall earnings growth that European companies had last year, it compares favorably with the 8 percent profit growth projected for domestic companies.

Of course, those are just estimates. And they’re likely to change as the year progresses, so it’s good to pay attention to them. They may be more important than those tarnished credit ratings.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=60941bb2b87179e3812fad01c939af08

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