By JONATHAN CHENG And MARY PILON
These days, the full faith and credit of the U.S. government may not be enough to impress the credit-raters at Standard & Poor's, Moody's Investors Service and Fitch Ratings. All three firms have placed the U.S. on watch for a possible downgrade from its vaunted triple-A position, which could come regardless of whether congressional leaders can find a way to avoid a default on Aug. 2.
S&P has gone the furthest, saying this week that failure to reach a "credible" deal could trigger a downgrade.
How to Play a U.S. Downgrade
How would markets react—a modest decline in the stock and bond markets? Financial Armageddon? An unexpected gain? It is a question that has small investors spooked.
Retiree Anita Greiner of Tulsa, Okla., says she is nervously following the debt-ceiling drama. "There isn't a lot I can do," she says. "We just try to invest in good stocks and secure things. I just have to put my faith in what I've invested in and hope for the best."
The range of possible outcomes is wide. The U.S. Congress could fail to reach a deal to raise the debt ceiling before Aug. 2, technically throwing the country into default and causing the government to miss payments to bond holders, Social Security recipients, vendors and others. Alternatively, Congress could reach a compromise before then and avoid any unpleasantness. But even in that case, the ratings firms could issue a downgrade if Congress merely raises the debt-ceiling without addressing the nation's underlying fiscal problems.
A downgrade, in turn, could affect the stock, bond and currency markets in ways that no one can predict. This past week, while the bond market remained relatively calm, stocks slumped, with the Dow Jones Industrial Average shedding 4%.
"Safety is a relative matter," says Claire A. Hill, a law professor at the University of Minnesota who has studied ratings agencies. "The dysfunction [in the U.S.] is on blazing display."
Other big nations have been downgraded in the past. S&P cut Japan's rating three times between 2001 and 2002, yet bond yields fell and the cost of borrowing declined. Canada, meanwhile, was downgraded in 1992, with little market reaction. But another downgrade in 1994 rattled markets.
Then again, comparing those nations to the U.S. isn't easy, because Treasurys play a crucial role as a safe haven in the global economy.
Mohamed El-Erian, chief executive and co-chief investment officer at Allianz SE's Pacific Investment Management Co., or Pimco, is paid to contemplate unthinkable events. "In the last decade, we've planned for 10 different financial crises," he says. "Two actually happened."
Mr. El-Erian still considers a credit default exceedingly unlikely. But he is worried that a downgrade would wobble an already weak economy, hurting stocks and the dollar and potentially helping bonds.
By contrast, Channing Smith, a portfolio manager at Capital Advisors Growth Fund in Tulsa, Okla., is concerned about the longer-term pain that could come from a budget deal that slashes fiscal spending to avert a rating downgrade.
"To preserve the credit rating, it's going to take $3 trillion to $4 trillion in cuts—and that's going to be a big drag on economic growth," says Mr. Smith, who manages more than $900 million in client assets. "It's not the end of the world to lose our triple-A rating. The bigger issue is: What's going to pump the economy up?"
Laurence D. Fink, chairman and chief executive officer of money manager BlackRock Inc., is more optimistic. He told analysts last week that selling stocks based on the gloomy news emanating from Washington was "a mistake," pointing to strong corporate earnings growth and strong global stock markets in general.
And then there are superbulls such as Mark Booker, a 47-year-old IT developer in Louisville, Ky., who sees a downgrade and any ensuing market volatility as a buying opportunity. "I guess I'm a contrarian," he says.
Mr. Booker manages his own retirement account and what he calls a "bingo account" for stock plays. He says he hopes to scoop up more shares of blue-chip companies he has long favored, such as General Electric Co. and Berkshire Hathaway Inc., on the cheap. Mr. Booker says that if the market tanks, he would ratchet up his overall exposure to equities by 2% to 5% from the current 80%.
Another scenario, of course, is that the debt ceiling isn't raised before Aug. 2, the U.S. is downgraded shortly thereafter—and nothing major happens. A similar event played out in 1995. In 1979, the U.S. briefly defaulted but quickly paid back creditors. In both cases, Medicare, Medicaid and Social Security payments continued to be made and markets weren't much affected.
So what might unfold this time, and how should investors react? Here is what some top money managers, advisers and economists are thinking—and doing—as the threat of a downgrade on the U.S. looms.
Lawrence Kemp
Head of Large-Cap Growth Equities, UBS Global Asset Management
Mr. Kemp, who manages more than $11 billion in client assets, is worried that the apparent abandonment of more ambitious plans to deal with the debt in the short term raises the likelihood of a downgrade-induced stock selloff.
Yet that, he says, could present longer-term buying opportunities.
"There's a very large sum of cash on the sidelines," says Mr. Kemp. "People are waiting to invest once they get clarity on the debt ceiling, a ratings downgrade and the European debt crisis."
He points to companies like Amazon.com Inc., which have continued to generate revenue growth by taking market share in one of those few corners of the economy still growing: e-commerce. "These are companies that are taking advantage of opportunities where there are tailwinds of growth," says Mr. Kemp, who holds Amazon shares.
David Waddell
President and Chief Investment Strategist, Waddell & Associates Inc., Memphis, Tenn.
If the U.S. is downgraded, Mr. Waddell says, the action would likely be centered in the bond markets, though that could lead to a knee-jerk tumble in the stock market—and buying opportunities.
"A default or a downgrade would disrupt the equity markets, but that's not going to stop Caterpillar from selling mining cranes to China," says Mr. Waddell, who manages $500 million in client assets.
The Standard & Poor's 500-stock index fell to 1292 from 1345 this past week. If it were to fall to 1250, the forward price/earnings multiple for the market would be at an attractive 12 times forward earnings—a level that has historically been marked by strong buying, he says.
He says the best opportunities could be in companies that can tap into the global economy, which is growing faster than the domestic economy.
Terry Belton
Global Head of Fixed-Income Strategy, J.P. Morgan
Mr. Belton says a near-term spike in Treasury rates isn't likely, even without a debt deal. Instead, he foresees in the near term a relatively muted increase in yields, which move inversely to prices, of about five to 10 hundredths of a percentage point, based on a survey of more than 40 asset-manager clients.
"Surprisingly, we saw a little more impact on non-Treasurys—corporate bonds, mortgages and agency-backed securities," he says. "There are some portfolios that are managed to an average credit rating, and to the extent that this pushes them below that, there may be some selling."
Mr. Belton says investors can capitalize on shorter-term volatility by buying Treasurys at bargain prices. "The Treasury Department isn't going to miss an interest payment—that's absolutely certain" even if there is no debt deal by Tuesday, Mr. Belton says. "Any of the short-term dislocations from this debate we see as more of an opportunity to buy some Treasurys that have cheapened up a lot."
He does, however, predict that over the longer term, a downgrade of U.S. debt would deter foreign Treasury buyers and raise yields by about 60 to 70 hundredths of a point.
Michael Yoshikami
Chief Executive and Chief Investment Strategist, YCMNET Advisors Inc., Walnut Creek, Calif.
"I expect a deal will be put together, but I'm less optimistic that any sort of deal is going to address the long-term structural problem that the U.S. has with deficits," says Mr. Yoshikami, who manages about $1 billion in client assets. "The markets are already starting to price in the loss of a triple-A rating."
Mr. Yoshikami says he expects a selloff in the stock market of about 10% in the days following a presumptive default, but says a ratings downgrade would probably be met with only a muted reaction from stock investors.
"There's so much negative sentiment toward U.S. governmental policy at this point that the market is already pricing it in," he says.
In the event of a downgrade, Mr. Yoshikami suggests selling off some longer-term bonds. At the same time, he argues that a downgrade would weaken the dollar, helping the stock prices of exporters and U.S. companies with significant operations abroad, like McDonald's and International Business Machines.
Jerry Webman
Senior Investment Officer and Chief Economist, OppenheimerFunds Inc.
Mr. Webman says a ratings downgrade could crimp the ability of consumers and businesses to borrow money, which in turn could dent corporate earnings in the longer term.
"That'll have a depressing impact on the U.S. economy and on companies highly levered to U.S. domestic growth," Mr. Webman says. "If monetary conditions become tighter, that's a negative for business."
That said, he expects only a temporary stock selloff after a downgrade, thanks to a strong earnings season. "About 75% of companies that have reported have surprised on the upside, and ultimately that's what drives stock markets," he says.
The upshot: Don't alter your long-term plan dramatically.
Kent Engelke
Chief Economic Strategist, Capitol Securities Management Inc., Richmond, Va.
Mr. Engelke, who helps manage $3.5 billion in client assets, doesn't think a U.S. debt downgrade is in the cards, but frets that the market hasn't priced in that possibility yet. If it happens, he predicts a stock selloff on the order of 2,500 points on the Dow Jones Industrial Average in the ensuing weeks.
"Just four weeks ago, the possibility of a downgrade was so remote, just a few people were talking about it—and we haven't prepared for that," he says. "The market has not priced this in yet—not with the 10-year Treasury yield under 3%."
Mr. Engelke points to the fact that nearly all borrowing in the country is based on Treasury rates, so any rise could lead to disruptions across the debt markets. Then there's the psychological impact that such a surprise would have, which he compares to the bankruptcy of Lehman Brothers in 2008.
His advice: Stay the course, given that a solution is likely.
Barry Allan
Chief Investment Officer, Marret Asset Management Inc., Toronto
Mr. Allan, whose firm has $6.5 billion in assets under management, says he began preparing clients for a downgrade and a subsequent short-term dive in equity and bond markets weeks ago. But he's telling clients not to gamble on various political outcomes.
"The propensity to be wrong is high," he says. "Who knows what politicians will do? They don't act the same way companies act. Politics is politics."
In the last three months, Mr. Allan says, he has "neutralized" the portfolios to what happens to the debt ceiling. Some clients have set up stop losses to sell in a rally and buy if prices dip deeply, he says.
And since many investors are still reeling from 2008, Mr. Allan says, he is cautioning clients that cash and Treasurys, typical safe havens, may be volatile. "In a sovereign-debt crisis, the traditional asset-allocation tools don't work," he says.
The firm is buying double-A and triple-A corporate bonds and betting against U.S. Treasurys because of the uncertainty in the direction of interest rates. He reasons that if there is a crisis in the U.S. dollar, well-capitalized corporations will be able to keep making debt payments.
Will Skeean
Partner, Edge Capital Partners, Atlanta
Mr. Skeean, who helps manage $1.8 billion in assets, says a U.S. downgrade "is pretty likely," and has moved client funds out of money-market funds and into plain old cash. His rationale is twofold: money-funds' low yields don't justify the risk, and the extra cash will help clients feel more confident of their flexibility should catastrophe strike.
He but stresses that there is no cause for panic. He is keeping long-term investors steadfast in their allocation to equities and commodities, reasoning that while there could be a selloff, there could also be a quick recovery.
While gold has been rallying, the firm isn't heavily invested, in part over concerns about the downside risk should investors try to exit the trade en masse.
Gus Sauter
Chief Investment Officer, Vanguard Group
On balance, Mr. Sauter is more worried about Europe than the U.S. He remains confident that Treasurys are still "money good"—meaning investors will get paid—and that any downgrade would be temporary. "We think Treasurys would continue to be liquid," he says.
Still, the firm is bracing managers and investors for volatility ahead. The market hasn't priced in the possibility that Washington will fail to reduce the budget deficit significantly, Mr. Sauter says. In 2008, most Vanguard investors stayed put with equities in their retirement accounts despite the stock-market freefall. Should there be another, Mr. Sauter says he hopes the same would hold true.
Jeffrey Gundlach
Chief Executive Officer, DoubleLine LLC
Any further delay on the debt ceiling causing a default "would likely be highly negative for the economy and cause Treasury yields to fall," says Mr. Gundlach, a longtime bond manager. The increasing concern could also put negative pressure on stocks.
Gold could hold up in such a climate, he says, but other commodities would likely fall alongside weakening economic prospects. If a downgrade happened because there were no debt-ceiling increase, then that could be positive for Treasurys, he says. But if the downgrade is the result of a debt-ceiling increase with no budget reform, that would be negative for Treasurys.
Even so, those effects would only be short-term. For investors in it for the long haul, "I don't think a downgrade will have long-term consequences," he says.
Write to Jonathan Cheng at jonathan.cheng@wsj.com and Mary Pilon at mary.pilon@wsj.com