How will a debt ceiling deal affect the Dow?

AP News
Posted: Jul 28, 2011 6:25 PM
How will a debt ceiling deal affect the Dow?

Market watchers are split over what stocks will do after there's a deal on the government's borrowing limit.

Two of them, AP financial markets writers Matthew Craft and David K. Randall, give their opinions on whether the Dow Jones industrial average will reach 13,000 or tumble down to 12,000:


How long till the Dow reaches 12,000? Give it a few days.

Big investors still believe Republicans and President Obama will agree to raise the borrowing limit in time to prevent the U.S. from defaulting on its debt after Aug. 2. But with the deadline uncomfortably close, many are cashing out just in case. The Dow is down 441 points this week. Expect more losses as the haggling drags on.

Maybe that's what Washington needs. A 777-point drop in the Dow in September 2008 is credited with forcing the House to pass a bill bailing out financial firms.

An agreement to lift the debt ceiling could send relieved investors back into stocks and set off a celebratory rally. But there's still a problem. Standard & Poor's has warned that anything less than $4 trillion in budget cuts will likely mean the U.S. loses its top AAA rating. When rating agencies downgrade countries -- as we've seen with Spain, Greece and Japan -- their stocks sink.

The debt deal itself could also send stocks falling. Federal spending accounts for 8 percent of the country's economy. A plan that drastically curtails it could further weaken a slow-growing economy.


It's easy to think that the market will keep falling. But don't underestimate investors' greed.

Eighty percent of the 190 companies in the S&P 500 that have reported second-quarter results have beaten Wall Street's estimates. Earnings from Microsoft Corp., Coca-Cola Co. and IBM Corp. had the Dow above 12,700 just a week ago. And as Dunkin' Donut's 46 percent pop on its first day of trading Wednesday showed, investors aren't running for the hills.

Once a deal is signed, expect a relief rally that even a one-notch credit downgrade might not extinguish. Why? Investors may already be assuming that there will be a downgrade.

That's not as scary as it sounds. Although a downgrade would take the ratings of Treasurys from the absolute safest security to the next-best level, that really wouldn't matter all that much. Borrowing costs for bond issuers and consumers would rise slightly at most, which wouldn't be enough to slow the overall economy. Even in the event of a downgrade, the market for Treasurys is so large that there will still be buyers.

A downgrade in the U.S. wouldn't have the same effect on its stock market as downgrades do in other countries. The companies in the Dow are giant-multinationals that rely less than ever on the U.S. for profits. Companies in countries like Spain or Greece tend to have operations that are regional rather than global. U.S. companies will still have plenty of reasons to rise, unlike their counterparts in Spain and Greece.

The best comparison for the Dow might be the Japanese market, which is also full of global corporations. After Japan's bonds were downgraded in 1998, its Nikkei stock index rose because the downgrade happened to come at the end of a recession. Few things excite stock investors as much as growth.