Another U.S. Credit Downgrade Looming?: SPY, VXX, XLP, PEP, COST

At the moment, the downward spiral that is Europe remains the markets’ current obsession. Whether Greece will soon be shown the door out of the Euro is up in the air, and what the fall-out of that would be for the rest of Europe seems about as clear as mud. One thing that is for sure is, it would be devastating for Greece. But, on a global basis, Greece is immaterial in terms of GDP, so its exit alone is not catastrophic by any means. Of course, the main concern is that once Greece is out of the crosshairs, all eyes would turn towards Spain and Portugal, with Italy on deck. This could lead to a rapid run on the banks in those countries as citizens begin to fear the end of the Euro as we currently know it.

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However, I am of the notion that the powers that be in Europe, out of desperation, will do whatever it takes to keep the Euro together. There is simply no appetite – and no road map – to break it up. Germany has been steadfast in its position against a Eurobond, saying its akin to “spreading a disease”, but once the much larger economies and banking systems of Spain and Italy begin to unravel, there won’t be much of a choice left. A Eurobond won’t solve the underlying issues of the Euro, issues that are intertwined economically, politically, and socially. It would, however, be celebrated by the markets in the short/intermediate term, and I would expect the SPDR S&P 500 ETF (NYSE: SPY) to rally. But, without doubt, it is only a “kick the can down the road” solution.

But, the old saying goes, “Those who live in a glass house can’t throw stones.” On Tuesday, May 22, the Congressional Budget Office released a report indicating that if the Bush Tax Cuts are allowed to expire, as is currently planned, and if the agreed upon budget cuts are put forth next year, the economy will slip into a recession in early 2013. This got much less press than the drama coming out of Europe, but I find this to be a much more significant risk to the market this summer.

We are rapidly approaching the proverbial “rock and hard place”, and the ones that are responsible to try and navigate us through it is our inept Congress. As of this writing, the U.S. national debt stands at $15.7 trillion, and the debt ceiling is currently set at $16.4 trillion. As a reminder, the debt ceiling is the legal cap set by Congress on the amount of money the government can borrow. It is estimated that we will reach that limit by the end of this year, but the negotiating, brinkmanship, and voting will take place before that.

As we head into the summer months, I fully expect more headline risks to hit the market, and cause more volatility, on concerns of government shut-downs, another round of worries about defaulting on debt, and renewed concerns of credit downgrades from the credit agencies. One such way to play this upcoming headline risk is to pick up shares of the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX).

As many recall, last August Standard & Poors downgraded U.S. Debt from AAA to AA+, the only firm of the major rating agencies to do so (Moody’s & Fitch stood pat). In regards to its downgrade, S&P stated: “The political brinkmanship of recent months highlights what we see as America’s grievance and policymaking becoming less stable, less effective, and less predictable that what we previously believed.” Well, things haven’t gotten any more agreeable in the beltway since then.

A couple weeks ago, House Speaker John Boehner said that he would not permit another increase in the country’s borrowing without a larger amount of spending cuts and reforms approved in tandem. So, here we go again.

In addition to Washington’s disfunction being on display again, the agencies will be looking for a credible plan to tackle the nation’s ballooning debt. I don’t believe a credible plan will be put into place. Like Europe, there is no political will to put forth the necessary tax increases and spending cuts to make a meaningful dent in the debt – especially since the CBO just said that doing so would put the economy into recession next year. So, instead, what the most likely outcome will be is this: After weeks of name-calling, threats, and maybe a government shut-down, some form of compromise will be made that will not go nearly far enough on either side. Not enough on the revenue side (taxes), and not enough on the cutting side.

This combination of not seriously fixing the problem, and the ineffective Congress will force the rating agencies’ hands. Yes, credit rating agencies have lost much credibility, but they are still a primary tool used in pricing debt. Should Moody’s and Fitch follow suit and downgrade U.S. debt, it not only will be another embarrassment for the country, but other countries may finally start to give a skeptical eye towards our debt. The last thing we need is for the government to have to shell out higher interest payments.

As far as how to invest and trade in this market, I believe it’s wise to take some money off the table, to hedge your positions, and if you want to be in equities, to choose stable, cash-flow, dividend paying companies. One way to hedge your portfolio is to buy insurance on it in the event the market takes a serious turn for the worse. The ETF that can provide that is the ProShares Ultra Short S&P 500 (NYSE: SDS).

In regards to individual stocks, Pepsi (NYSE: PEP) is a solid, consumer staple stock that currently has a dividend yield over 3%. It also recently popped above a key resistance level at $67, setting the stage for a run higher.

Another stock worth considering is Costco Wholesale (COST) as a play on softening consumer spending. On May 24 during a presentation, management stated that new member sign ups were quite strong and renewal rates continue to be strong. Also, COST is making a push to grow internationally.