Evening Market Update

Fear Takes Hold

US equity markets were hammered, closing at the lows of the day, following the US credit rating downgrade by Standard & Poor’s on Friday, with Treasuries finding solid demand, as traders sought shelter from the malaise on the Street. Continuing eurozone debt crisis contagion fears further stymied sentiment, despite the notion that the European Central Bank will begin purchasing Italian and Spanish debt. Crude oil prices were solidly lower and gold prices soared, while the US dollar was mixed, gaining versus the euro but losing ground against both the Japanese yen and Swiss franc. Financials and energy stocks led the broad-based decline, with Bank of America finding further pressure amid a lawsuit filed by American International Group, while Dow member Verizon Communications gained attention after workers went on strike over the weekend, fellow Dow component McDonald’s saw solid sales during July, and United Continental Holdings reported a decline in traffic in July.

The Dow Jones Industrial Average tumbled 635 points (5.6%) to 10,810, the S&P 500 Index fell 80 points (6.7%) to 1,119, and the Nasdaq Composite dropped 175 points (6.9%) to 2,358. In very heavy volume, 2.5 billion shares were traded on the NYSE and 4.0 billion shares changed hands on the Nasdaq. WTI crude oil dumped $5.57 to $81.31 per barrel, wholesale gasoline lost $0.14 to $2.69 per gallon, and the Bloomberg gold spot price surged $54.50 to $1,718.45 per ounce. Elsewhere, the Dollar Index—a comparison of the US dollar to six major world currencies—was 0.2% higher at 74.70.

Bank of America Corp. (BAC $7), already underwater as financials were one of the sectors that led the broad-based decline, came under further pressure, finishing over 20% lower, following news of a lawsuit filed by American International Group Inc. (AIG $22). The suit, which alleges that the bank and its subsidiaries sold faulty mortgages, is seeking $10 billion in damages, as a result of $28 billion in securities the bank sold AIG, as well as Countrywide Financial and Merrill Lynch, both of which BAC acquired in 2008. Also weighing on the bank’s shares, CNBC reported that hedge-fund manager David Tepper sold his entire stake in BAC, amounting to some 17 million shares. However, in commenting on today’s events, a spokesperson for BAC said that the company has the right strategy and management and sees no need to raise capital. AIG finished lower as well.

Dow member Verizon Communications Inc. (VZ $33) was in focus today, as 45,000 workers went on strike over the weekend as the company and its union failed to reach a new labor agreement after their contract expired. The work stoppage is centered in VZ’s wireline business opposed to its wireless service and the company said its customers should expect no changes to network quality during the strike, which is the first in 11 years. Shares were lower.

Fellow Dow component McDonald’s Corp. (MCD $82) reported July global same-store sales—sales at stores open at least thirteen months—rose 5.1% year-over-year (y/y), as European sales increased 5.3%, led by growth in the UK, Russia, and Germany. Elsewhere, same-store sales in the US rose 4.4% and 4.0% in its Asia/Pacific, Middle East and Africa segment. Shares were lower amid the broad-based sell-off in the equity markets.

United Continental Holdings Inc. (UAL $17) reported that its traffic in July dipped 0.1% y/y—the third-consecutive monthly decline per Dow Jones News Wires—though the air carrier’s consolidated passenger revenue per available seat mile for its United and Continental airlines increased 7.5% y/y. Shares came under heavy pressure.

Treasuries higher despite S&P downgrade of US credit rating

AIG $22). The suit, which alleges that the bank and its subsidiaries sold faulty mortgages, is seeking $10 billion in damages, as a result of $28 billion in securities the bank sold AIG, as well as Countrywide Financial and Merrill Lynch, both of which BAC acquired in 2008. Also weighing on the bank’s shares, CNBC reported that hedge-fund manager David Tepper sold his entire stake in BAC, amounting to some 17 million shares. However, in commenting on today’s events, a spokesperson for BAC said that the company has the right strategy and management and sees no need to raise capital. AIG finished lower as well.

S&P lowered its long-term credit rating on the United States to AA+ from AAA. At the same time, it affirmed the A-1+ short-term rating and removed both ratings from credit watch, but held the long-term outlook as negative. This means that another downgrade is possible within the next two years if there is less deficit reduction than expected or economic or financial conditions change, as Schwab’s Fixed Income Strategist Kathy Jones discusses in her article, US Credit Rating Downgrade, noting that S&P’s rationale for the downgrade was its assessment that the recently negotiated budget agreement fell short of what is needed to stabilize the rising US debt. An additional factor for S&P was the contentious nature of the budget process itself, which has reduced its confidence in the ability of policymakers to address rising US deficits.

Kathy adds that it's important to remember that a credit rating is an opinion issued by a private organization, not a seal of approval. And S&P is only one of three major rating agencies. The other two--Moody's Investors Service and Fitch Ratings--have not lowered their ratings, although they assigned a negative outlook. Nonetheless, credit ratings do matter. Investors use credit ratings as a standardized way of assessing and comparing the risks of various issuers and securities, just as banks often use credit scores to assess the risk of an individual borrower. It is only one of many metrics that investors use when buying bonds, but it is an important one. While the downgrade by S&P may be potentially disappointing for the markets, we don't believe that it will necessarily cause borrowing costs to rise or that it will have much impact on the real economy in the short run. It is the opinion of one entity, albeit an influential one, but our view is that the impact is likely to be limited. It may cause some erosion in investor confidence in the near term. Of course, if the longer-term budget issues are addressed in a credible way, we would expect confidence to recover.

Meanwhile, there were no major economic reports scheduled for release today, but this week’s data kicks into gear tomorrow with what will likely be the headlining event, the conclusion of the Federal Open Market Committee’s (FOMC) monetary policy meeting. No major changes to the Fed’s stance are expected and the statement will be released at 2:15 p.m. EST. In light of the dramatic events in the market recently, traders will be looking for any signs on whether the recent string of soft data and decline in confidence will evoke a response hinting to a new round of quantitative easing (QE3). The Fed downgraded its assessment of the economy at the last meeting, citing some temporary factors, but in the press conference following the meeting, Fed Chair Bernanke said some of the headwinds such as weakness in the financial sector and housing market “may be stronger and more persistent than we thought.” Nonetheless, Bernanke quelled ideas about a potential QE3 by saying that differences from last fall included improvement in the job market and the mitigated risk of deflation.

Other reports slated for release tomorrow include non-farm productivity, forecast to decline 0.9% during the 2Q following a 1.8% rise in 1Q, while unit labor costs are expected to gain 2.4% during the same period, after moving 0.7% higher in 1Q. The NFIB Small Business Optimism Index will also be on the docket.

Negative sentiment shared globally

The uneasiness regarding the downgrade of the US credit rating by S&P hampered sentiment across the pond, overshadowing the European Central Bank’s (ECB) statement late-Sunday that suggested it will purchase bonds of Italy and Spain. The ECB said it will “actively implement its Securities Markets Program” after purchasing Irish and Portuguese bonds last week, aimed at combating contagion of the euro-area debt crisis that has threatened key eurozone nations of Italy and Spain. Stocks in Spain and Italy gave up early gains and were lower as the boost from the expected bond purchases by the central bank, which sent yields on Italian and Spanish bonds lower, waned. Moreover, the euro gave up early gains and was lower versus the US dollar. Meanwhile, the steep declines in the major European equity markets came despite finance ministers and central bank governors that make up the G-7 and G-20 pledged to “take all necessary measures to support financial stability and promote growth.”

The economic calendar across the pond was relatively light and took a back seat to the focus on the global debt concerns, but reports showed business sentiment in France dipped slightly in July, and eurozone investor confidence unexpectedly fell into negative territory for August.

Meanwhile, the markets in Asia posted solid broad-based losses as sentiment was rattled by the late-Friday US credit rating downgrade by S&P and the festering eurozone debt crisis. The steep declines in the region came even as the G-7 and G-20 pledged to support financial stability and after Japan said it was prepared to intervene in the currency markets if speculative trading drives the yen higher.

International releases for tomorrow include, Germany’s trade balance, the UK’s industrial production and trade balance, consumer confidence in Japan, housing starts in Canada, while China will release CPI, PPI, retail sales, industrial production and fixed asset investment.