After several months of not-so-subtle hints, ratings agency Standard & Poor’s (S&P) cut the US government’s credit rating to AA+ from AAA for the first and only time since 1917. The agency cited a partisan atmosphere in Washington for the downgrade. Amid political “brinksmanship” in the capital, S&P said it had grown difficult to predict the direction of US fiscal policy and called into question the government’s ability to manage the country’s finances. Global stock markets have spiraled today as the markets digest news.

But investors shouldn’t be surprised by the move. S&P had signaled for months that it would downgrade US debt. The agency assigned a negative outlook to US debt in April and placed the US on its CreditWatch list in July. As politicians in Washington bickered over whether to raise the US debt ceiling, S&P made it clear that a $4 trillion deficit reduction would be necessary to maintain the AAA rating. Now that Washington has delivered a $2.1 trillion debt-reduction deal, S&P has simply stayed true to its word.

Nevertheless, the downgrade strikes a blow to the country’s creditworthiness and credibility. But more troubling are the knock-on effects that could result from the downgrade. On Aug. 8, S&P downgraded farm lenders and mortgage debt issued by Fannie Mae and Freddie Mac, as well as a raft of banks and credit unions, and three major clearinghouses that execute trades in stocks and bonds. A number of municipal debt issuers saw their ratings cut as well. The one common bond between all of the downgraded entities was a reliance on federal spending.

Although the downgrade is a blow to the nation’s pride, it may prove a blessing in disguise. The research note that accompanied the downgrade clearly stated that the move was tied to political “brinksmanship” in Washington; it’s an assessment of our political class and not the economy. Perhaps the downgrade is precisely the event that will force US politicians to compromise and govern.  

The downgrade will likely result in significant economic challenges such as higher borrowing rates. But there’s little need for any drastic portfolio moves. Equities will suffer as investors lose their appetite for risk. But Treasury yields are actually falling across the curve despite the downgrade. At this stage of the game, it appears that investors still view Treasury bonds as the safest game in town.

Meanwhile, there are some bright spots in the economy that suggest a second recession in unlikely. About three quarters of the S&P 500’s constituent companies beat earnings estimates in the second quarter on tighter cost controls and improving demand. Corporate balance sheets remain solid with large cash positions and low debt levels. Regional data indicates manufacturing activity is improving slowly and the Leading Economic Index is on the rise.

We will analyze the implications of the downgrade at length in Wednesday’s issue of Global ETF Profits. For now, we do not recommend any Portfolio moves, as the fundamentals of the global economy remain unchanged.