When the public hears news that a major nation takes a major credit rating downgrade, it should bring at least some cause for concern. After all, it can imply that a nation’s creditworthiness and economic prospects are not living up to the full potential. China has been called the “World’s Growth Engine” for years, but Moody’s issued a credit rating downgrade on it. Moody’s downgraded China’s sovereign rating to A1 from Aa3 in the call, and Moody’s has now changed its outlook to Stable from Negative.
24/7 Wall St. wanted to give a primer about what this might mean for the global markets. More importantly, we wanted to show what the downgrade of China really means to you and your money.
The very first consideration here is that the downgrade perhaps was not totally unexpected. Moody’s had downgraded the outlook on China’s Aa3 rating to Negative from Stable back in March of 2016. That was the first major hint that a downgrade was more likely, and it took more than a year to reach a formal downgrade verdict.
Moody’s said that this key downgrade reflects the ratings agency’s expectation that China’s financial strength will erode somewhat over the coming years. The agency also noted that China’s economywide debt will continue to rise as potential growth slows. While Moody’s noted that the ongoing progress on reforms is likely to transform the economy and financial system over time, the ratings agency feels that it is not likely to prevent a further material rise in economywide debt. The agency also warned that contingent liabilities will increase for the Chinese government.
Again, the downgrade may sound harsh. The new “stable” outlook is meant to indicate that the balance of risk and upside are now adequately reflected in the larger global macroeconomic picture. Another safety-net consideration is that nations the size of China, the world’s largest economy, historically do not face multiple credit rating downgrades in a short period unless there are major risks. According to Bloomberg and to the Telegraph (U.K.), this was the first time Moody’s downgraded China since 1989.
Moody’s outlined why the Stable outlook showed that major concerns might be overblown. Its report said:
The stable outlook reflects our assessment that, at the A1 rating level, risks are balanced. The erosion in China’s credit profile will be gradual and, we expect, eventually contained as reforms deepen. The strengths of its credit profile will allow the sovereign to remain resilient to negative shocks, with GDP growth likely to stay strong compared to other sovereigns, still considerable scope for policy to adapt to support the economy, and a largely closed capital account.
What investors need to consider is that Moody’s has no serious worries that China will have problems paying its bills, even if its downgrade warned that it expects China’s economic leverage will increase further over the coming years. Another consideration is that much of China’s debt and assets are internally owned. That should help to insulate investors taking massive losses outside of China, even if there is yet another shock in the nation’s markets.
24/7 Wall St. took a look at the global markets and their reactions to the credit rating downgrade. The reaction in key exchange traded funds and American depositary shares tracking Chinese stocks might almost seem positive based on the muted reaction, and it was surprising to see that some of the key trackers were trading higher.
It is also not unprecedented for a major nation to face a credit rating downgrade. The United States of America was downgraded by S&P back in 2011, and the U.S. government reacted by questioning the credibility of S&P at the time. U.S. bond yields actually went lower rather than higher. It turned out that the relative credit risk threat of the world’s reserve currency and debt did not drive up U.S. borrowing costs at all.
China’s Ministry of Finance has issued its own reaction to Moody’s, calling the Moody’s argument on Chinese debt “absolutely groundless.” The ministry’s view is that Moody’s has underestimated the government’s capabilities to deepen reform and boost demand.
World markets might have initially been weak when the downgrade was announced, but the major indexes all bounced back. The Dow Jones Industrial Average was last seen up 25 points and just 37 points away from the 21,000 mark. The Nikkei 225 in Japan closed up 129 points at 19,742. And in China, the Shanghai Stock Exchange’s SSE Composite closed up two points at 3,064.08, and the Hang Seng (Hong Kong) closed up 25 points at 25,428.50. Maybe those gains are too small to be considered good news, but it’s hardly reason to worry about a 1929 U.S. stock market crash.
There is another consideration here about the credit rating downgrade’s timing. It is frequent that such sovereign downgrades occur on Friday. Whether this is for the nations to be able to react or to give absorption time for the markets may be up for debate. Still, the downgrade took place midweek and the markets just did not panic.
Before hitting the panic button and running for the hills, it is important to understand that the investing community often reacts differently than what the headlines might indicate. Hint: Think about back when S&P downgraded the United States of America and stripped away its prized AAA credit rating on August 5, 2011.
The S&P was at 1,200 the prior day and was at 1,199 on that Friday ahead of the downgrade. By the close on the following Monday, the S&P 500 was down to 1,119. But guess what happened. The S&P 500 was back up to 1,200 by August 15, 2011. The investors understood that it was not the end of the world, and the S&P 500 is now pushing back up against 2,100 and is up 88% from the August 2011 lows.
Investors and economic watchers have now seen how the markets reacted to this, perhaps with a lack of a reaction. If this was going to act as a prelude to a crash, it already would have been seen in the markets. Investors have become used to slower growth out of China. By the sound of it, they might need to expect even slower growth ahead.
In each morning’s daily analyst calls, 24/7 Wall St. has pointed out not just that the bull market is now over eight years old. The biggest issue to consider is that investors have literally bought every single pullback within that bull market for more than five years now. The reasons for buying each pullback change each year, but investors have so far been proven right by going with the world’s top stock markets rather than fighting against them.