8 augustus 2011
The downgrade of U.S. sovereign credit by S&P on Friday reflects facts that have been well known to the market for some time.  So, it does not imply a fundamental increase in risk, and we don’t believe that investors should change their behavior based solely on the downgrade.  However, in combination with continued economic weakness and regulatory uncertainty, this may provide a signal to some investors to reassess their risk appetite. BlackRock has been preparing for the possibility of downgrade over the past month, and, the firm has no need to execute any forced selling of securities in response to the S&P action.  In anticipation of a potential ratings downgrade, BlackRock had a task force from across the company review all aspects of our business that transact in U.S. Treasuries and related securities and developed a detailed game plan to follow in the event of a downgrade, which we have executed throughout the weekend. 

We also are prepared for continued downgrades into next week of the many other issuers and issues that derive their rating from the U.S. government rating – including the GSEs and some corporates. While we have worked closely with our clients to clarify their investment guidelines, and to inform them of possible market reactions resulting from a downgrade of U.S. sovereign credit, this is but one of myriad concerns investors face in markets today. Much of the developed world faces high levels of indebtedness, slowing economic growth, and significant potential for policy missteps.

Taken together, these elements have dramatically increased market volatility and reduced liquidity.  The weakness in labor markets, when combined with only modest levels of growth, argues for a high likelihood that the Federal Reserve will maintain its Fed Funds policy range at historically accommodative levels for at least another year and perhaps through 2012.  Moreover, we believe the Fed will want to continue supporting the recovery in any manner it can  in light of an extraordinarily anemic real growth rate of 0.4% for the first quarter of 2011, revised downward from 1.9%, and a below consensus estimate of 1.3% for the second quarter,. Alongside these fundamental concerns over the status of the economic recovery in the U.S., the expanding European sovereign debt crisis continues to heighten the risk of a significant slowing in European growth. The European crisis highlights the impact that slow moving and poorly conceived policy decisions can have on financial markets. 

At its core, liquidity has been provided to attempt to address a solvency problem, and sovereign credit markets have remained unconvinced of the ultimate efficacy of each successive "solution" to the widening of peripheral country debt spreads. Nonetheless, we think it is vital to underscore the fact that the U.S. Treasury sector (and to a slightly lesser extent Agency-backed MBS) remains the largest and most liquid fixed income market in the world with the greatest degree of price transparency and few genuine alternatives. 

While the events that led to the S&P downgrade are certainly of concern, we think the vast majority of investors will continue to utilize the Treasury yield curve as an effective credit risk-free benchmark against which credit spread issues can be judged.  Treasuries will also continue to see a strong bid from institutional investors of all kinds (including banks) and will continue to serve their traditional role as a hedge to risk assets.  While a time may come when the credit risk-free status of Treasury bonds is diminished by continued policy missteps, we do not believe that the S&P downgrade signals that this moment has come now.  Addressing the fiscal challenges that confront the United States is a long-term undertaking. 

Those challenges cannot be overcome through short-term fixes but will require efforts extending over many years.   The U.S. economy has historically been the world’s most resilient, but its future depends on policymakers coming together to make the hard decisions needed to arrest the growth of the U.S. public deficit.   There is time to address these challenges, but if policymakers fail to do so, this weekend’s credit downgrade will be a sign of continued fiscal deterioration.