Investors Bracing for Market?s Reaction to S&P Downgrade

The stunning decision by Standard & Poor’s to downgrade the long-term credit rating of the United States government to AA+ from AAA will surely raise questions about investor confidence in the economy and throw the equity markets into more turmoil.

The great unknown is, how will U.S. equities (which have already been hammered over the past two weeks) respond to this shocking development? And will there be a long-term lingering impact on stock price performance going forward?

Part of the problem is that the downgrade (while perhaps not a total surprise) arrived somewhat unexpectedly – and during a period when markets are already extremely volatile and fragile.

George Goncalves, chief Treasury strategist for Nomura Americas, told CNBC: “I did not expect this [downgrade] to happen this soon. This is something they gave the criteria on and I guess they stuck to it. I really thought they'd take the two-stage approach and see how further [spending] cuts would come along."

Goncalves added: "In the moments in the past when large countries were downgraded, our analysis shows there is some volatility. It depends on the market conditions. I don't think given the environment we're in right now, this was the optimal time to be seeing a downgrade of the largest nation in the world. The only fear I have is that after a pretty rough week in the risk markets, how is this going to be perceived by investors.”

Among other issues the downgrade raises: what will happen to pension funds which are required to only hold AAA-rated securities? In the event they engineer a massive sell-off of Treasuries, bond yields would go through the roof.

Laura LaRosa, director of fixed income at Glenmede, an investment and wealth management firm in Philadelphia, Penn., told The Wall Street Journal: “[The downgrade is] a game-changer. With Europe in the situation that it is, adding the U.S. to the problem is just really bad for world financial markets."

She added: "People who are more focused on equities have said they were prepared for it. They said it was supposed to happen. But I think the bond market is not going to take it as easily as the equities guys will. Bond prices will go down."

Indeed, some analysts think that the downgrade may already have been priced into the market (there were indeed rumors that the downgrade was coming as early as Friday afternoon, which led to a huge stock sell-off later that trading session).

Christian Thwaites, president and chief executive at Sentinel Investments, told The Journal: "It'll be business as usual come Monday. This has been well priced in. S&P had been talking for a while about this. Their credibility has certainly taken a hit, so they obviously felt a need to follow through."