While the downgrade covers all US obligations, the market impact should be most visible in the Treasury bond market. The major fear is that the US will witness an increase in borrowing costs which translates into higher yields. This will come in the form of either a selloff in Treasury bonds bringing prices down thus increasing the yield on existing bonds or through lackluster demand the next time the US treasury auctions new bonds forcing it to pay a higher interest rate. That is the theory, however in practice we believe that there will be little or no material impact on the Treasury bond markets come Monday.

While S&P’s, and other rating agencies’, opinion are of tangible and practical value to most investors, the value of these ratings decreases with 1) the size and transparency of the issuer, 2) the level of complexity of the particular instrument being rated, and 3) the availability of an existing market in an identical security by the same issuer. Furthermore, when it comes to US treasuries, or any other instrument, we posit that ratings are IRRELEVENT to those who have no choice but to buy them.

Credit ratings, by definition, are an opinion on an issuer’s willingness and ability to pay its obligations. When a bond is issued and starts trading, the market becomes the best judge of an issuer’s ability and willingness to pay and a bond’s yield becomes the best measure of this. However, when it comes to fixed income securities in general, and sovereign bonds (such as Treasury bonds) in particular, the market price is also a vote on the value of the currency that the bond is denominated in. (A bond’s liquidity is also reflected in the price as well).

The reason for this long introduction is to lay out the reason why nothing practically has changed. The US ability to pay its obligations should never be in question because its obligations are denominated in US dollars and whenever those obligations come due the US treasury can print as many dollars as needed if there wasn’t enough on hand. However, this downgrade has a bit to do with the US willingness to pay its obligations as the US came very close during the debt ceiling debate to defaulting on its obligations by simply opting not to take the necessary steps to doing so. However this downgrade came after this has been averted and remedied.

It is because of the US ability to pay its obligations, US treasuries, and in turn the US dollar, have always been the premiere safe haven of choice for all investors – particularly those who have US dollars to invest. This category includes all investors within the United States, but also all of the US trade partners who have a trade surplus with the United States such as China and the oil producing Gulf states. Hence, if you need safety of principal and you have a gigantic amount of US dollars to invest, then in reality you have no other market that is as big, safe and liquid as the US Treasury bond market.

Impact on financial markets and economy:
While we established above that there should be little or no impact on the Treasury bond market, the impact of the S&P downgrade on US stocks and global financial markets is less clear. In a world where the US economy is slowing down and many European nations are battling prospects of insolvency, it is normal to expect a trend by global investors to reduce risk. In our view, emerging markets will bear the brunt of this global de-risking as emerging markets by definition are riskier than their more developed counterparts. In Europe, it looks more likely that we will see a coordinated plan of defense by the European Central Bank and the European Union that extends a safety net to the markets similar to what we have seen with Greece and Ireland. However, in a global state of de-risking it is not inconceivable that US treasuries and the US dollar will be the beneficiaries of fund flows out of the Euro region.

As for US stocks, we think that the economic slowdown and the fairly modest job growth that we have experienced during the first seven months of 2011 are the main factors weighing in on equities going forward. In this regard, the prospects of a new round of monetary easing by the Federal Reserve, similar to QE2, becomes more likely the more weak or disappointing economic reports we see. However, now that S&P actually went ahead and downgraded the US credit rating we believe that there is less of an incentive for the US government to reduce fiscal spending to maintain a AAA rating that has been already lost. That along with the fact that we are entering into the 2012 election cycle, we believe that a government stimulus targeted towards job creation is more likely as it will be hard to envision, today, that the current administration or even many Republicans in Congress would be re-elected with an unemployment rate north of 9%. This being said, equities should remain volatile for the duration of the third quarter, and particularly this month, until new stimulus is announced and is implemented.

The above illustration is important as it helps explain the strengths of the market so far and it also sheds a light on how concentrated the gains have been so far. If the performance in March is an indication of how the market will perform in April then more volatility and sector rotation might be ahead while industrial stocks might continue their steady advance.

One can argue that the Energy sector’s performance was propped up by all the geopolitical risks in the Middle East and that we witnessed a wave of profit taking in March as traders took profits (in Energy related stocks even though spot oil prices fluctuated but kept going higher) as the specter of oil supply disruptions decreased as the situation in Bahrain cooled down and as the situation in Libya was fully priced in the markets by the end of month. If that is the case then one can expect the Energy sector to under-perform the market as soon as geopolitical risks abate. While this is hard to predict, or model for, and while the situation in Yemen may have negative repercussions on Saudi Arabia, we currently know that aside from Libya there aren’t any ongoing military actions taking place in any other significant oil producing country.

While the first quarter started with the general view that the Federal Reserve was there to prop up asset prices (stocks and commodities) with its second round of quantitative easing (there were even some rumors in January and February that QE3 was in the works), April is starting on the heels of relatively strong economic reports the last of which was the March unemployment report that showed a steady increase in job creation and a mild decrease in the unemployment rate. So talk of QE3 are out and the more hawkish members of the FOMC have been all over the wires and airwaves predicting FED tightening sooner (this year)rather than later (next year). This will certainly add to market uncertainty this quarter and, in our opinion, will put downside pressure on commodity prices.

However, countering this uncertainty is the fact that the US economy is certainly improving and that economic reports should reflect that in the months ahead. Given the fact that the S&P 500 is trading near its highs for this year (and for the past 3 years) around the 1340 levels, we believe that much of this anticipated economic recovery is already priced in and hence we advocate a more cautious stance as we enter April and go through earnings season.

Where to Invest in the Second Quarter:

Our two favorite sectors for this quarter are Healthcare, particularly biotech, and Financial Services. The Healthcare sector slightly underperformed the overall market during the first quarter with an advance of 5% versus almost 6% for the market overall. We believe that healthcare stocks will offer a safe haven for investor capital during the second quarter as we see money coming out of commodities and going into more defensive sectors with strong growth potential. Hence, we are more bullish on biotech stocks rather than the big pharmaceutical companies as we see added investor, and M&A, interest in these companies that are working on the next generation of leading edge drugs. One of our favorite stocks in this sector is Seattle Genetics Inc. (SGEN).

One bright spot continues to be the financial services sector. While many bank related stocks sold off after regulators allowed banks to increase their dividends, the announcement itself gives an important insight into the banks’ financial health and, one can argue, into their anticipated first quarter results. Does anyone think regulators would allow a bank to raise its dividend if this bank is going to miss or report bad Q1 earnings? Add to this, the fact that the Federal Reserve received high levels of interest for the sale of the assets of the Maiden Lane II investment vehicle that contained some of the most toxic assets at the time, residential mortgage-backed securities, that were taken off AIG’s balance sheet at the height of the financial crisis. The high level of interest and the Fed’s decision to sell these assets in the open market is an added insight that a lot of these same assets that are still on many a bank’s books have increased in value and many of these banks should be reporting improved capital positions going forward. We view the current weakness in many bank stocks as a buying opportunity and some of our favorite stocks in this sector include Fifth Third Bancorp (FITB), New York Community Bancorp Inc. (NYB), E*TRADE Financial Corporation (ETFC), and the preferred shares of Bank of America Corporation (BAC-D).