Now it is official, US Treasury bond is rated as AA+, not AAA by S&P.  it is the first time in history that the US government bonds were downgraded by a rating agency.  (although in early days of America, government bonds performed much worse.)

What does this mean to investors?  Well, higher borrowing cost for the Treasury and lower stock price overall. When the WACC (weighted average cost of capital) moves up, equity valuation will move down. In the world of institution investors, we used 10 year Treasury yield as the benchmark “risk-free” rate of return.  We know that Treasury is anything but “risk free”.  It should be treated as a risky asset like other financial assets.

Athought Treasury is not "risk free", it is still the benchmark.

It should NOT be shocking to investors at all as the debt issue has been well broadcast, and has been the concern for decades.  The AAA+ rating should not mean anything to investors given the financial health of US government.  However, I will not be surprised to see market to be 5-15% lower. That number is what I got when I plug in the  “new” risk free rate of return in the DCF (discounted cash flow) model to calculate the fair valuation of the S&P 500, depending on various scenario of economic outlook. The interest rate of AA+ and AAA bonds is really very close, with a spread about 10-50 bp.  Hence, change in the discount rate is not significant by the downgrade.  what is important is the psychological impact on investor's confidence, and ripple effects on consumer spending and global economy.

When discount rate used to value a financial asset goes up, the price of the asset falls. We value stocks based on the risk free rate plus equity premium.  In practice, we use 10 year Treasury yield as the bench risk free rate, because valuation is based usually on a 10 year DCF. Assuming everything else being equal  (which is not very realistic, I will comment later), i.e. cash flows stay the same, the rising discount rate brings down the fair valuation of the market. 

After recent market corrections, I would argue that  the downgrade has been partially priced in.  I do not expect market to collapse by the downgrade.

ANOTHER LOST DECADE IN STOCK MARKET

There were slight optimisms recently that the market will do better between 2010-2020 than previous decade after passing the unprecedented global financial crisis. Global stock valuation is reasonable, even cheap in some aspects.  Economy is in a gradual recovery.  Monetary policy is loose, and consumers are retuning to stores. And China growth story is told again and again as we do not have other story.

Nevertheless, I view the world quite differently.

First, inflation will be a lot higher, everywhere.  We may repeat the history of 70s when inflation hit teens and economy stagnated.  With the astronomic number of money created by central banks in recent years, it is only a matter of time when the inflation is reflected in the economy.  Indeed in many countries, it already has been.  Inflation, as measure by CPI, has little credibility with average consumers because they are experiencing significant inflation and loss of purchasing power. 

Second, economic growth will be significantly slower in this decade comparing with the previous one.  The low rate in US, which created a housing bubble and buying spree, has ended.  In a world of overcapacity of producing almost everything, the demand determines the rate of economic growth.  Supply is not the bottleneck (except iPad) as the world is abundant with labor and capital.  It took 40 years to make radio set to every home, and about 20 years to make TV everywhere.  However, the world produced 1.8 billion cellphones in 2009, and we have only … 7 billion people on earth. 

With retreating by consumers in developed economies, and yet-to-come spending by Chinese consumers, global demand will be much weaker. Forget about the ~4% global GDP growth, I will be happy to see number in positive territory.  1% GDP growth may be the number we should look forward to in this decade. 

With slower GDP growth (and hence slower corporate earning growth), and higher discount rate, why do you still believe the stock market will reward you?  Those 2 factors are the key determinants of stock valuation, and they all point to a lower place for the market.  Arguable, global stock valuation is cheap, and the world is NOT all doom and gloom. There are positive spots I can point out, such as the consumers in emerging economies and innovation and productivity of corporate America. I do not foresee a collapse of global stock market in the near future. 

However, I will be not be surprised or disappointed if the market stays in a close trading range for years.  What do you do in this trendless, range bounding market?

Play golf, lots of golf.