Some are calling 5 August 2011 – the day that ratings agency S&P downgraded US debt – as the day US hegemony was lost. The US economy, once the most powerful in the world, now sports a AA+ rating, down from the top AAA rating. Countries like Australia, Canada, France, Germany and Switzerland are currently rated safer than the US economy. Due to the downgrade, the US may face even higher interest payments on its mounting debt, raising the likelihood of a future US default.

Markets this week will be nervous in the wake of the downgrade. Interestingly, it’s not the first time that a large economy has suffered a downgrade; Japan lost its triple A rating in 2001 and after the earthquake in March it was lowered further to an AA- rating.

But most concerning for Australian investors will be the impact of the downgrade on Asia, and China specifically, as the Australia’s growth rate is vulnerable to any fallout in Asia.

The downgrade is most troubling for China since it is the largest holder of US debt, estimated at $1.2 trillion, which is almost one-third of its currency reserves.

China’s state run Xinhua News Agency responded with this statement: “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone…China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.” China has also called for a new global reserve currency.

The Chinese economist Sun Lijian said in the People’s Daily: “The biggest victims may not be the United States itself, but other countries that have depended on external demand to amass national wealth – be they Asian nations that depend on exporting goods, or nations in Latin America and the Middle East, as well as Russia, that depend on exporting resources.”

Australian investors should watch closely for any fallout in commodity prices. Fears of another US recession could be the catalyst that sends commodity prices lower, as investors brace for slower global demand. This could significantly depress share prices of the materials sector.

Gold, however, will probably test new highs as investors’ turn to gold as one of the few safe-haven investments.

Some argue, however, that commodities prices could actually rise as investors buy commodities as a proxy for investing in China. China is in a good fiscal position and is growing strongly, which contrasts markedly to the imploding debt levels in Europe and the US. China’s tight supplies over coal and iron ore should also provide some support.

Ivan Colhoun at ANZ Research believes that the markets reaction to the news may be far from rational. “I would expect commodity currencies and equities to be the major casualties.” He thinks the Swiss Franc and the Japanese Yen will benefit, and the Euro will face further downward pressure.

Both the PM and Treasurer are confident that China will save the day for Australia, with PM Jullia Guillard saying: “When we look at our own economy, people understand that a quarter of our exports go to China with its huge demand for our resources, that what we are therefore seeing are the best terms of trade in 140 years.” Treasurer Wayne Swan agrees that Australia is in the right part of the world at the right time, saying: “The prospects for our region remain much stronger as the weight of global activity continues to shift from West to East.”

Nevertheless, there’s little denying the fact that the US economy is in trouble and US citizens face a long and drawn out road of unemployment and austerity measures. Europe, too, will be in the doldrums for years as Governments react to demands to cut Government spending and increase taxes.

The big question is whether Asia can continue charging ahead at break-neck speed as the US and Europe face recession. Many of China’s exporters depend on US consumer spending; the US trade deficit with China hit a record $273 billion in 2010.

The impact may be felt in already fragile consumer sentiment. This is particularly worrying for Australia, which already faces a sluggish retail sector as consumers, worried about the future, become increasingly risk adverse.

More articles from this week’s newsletter

18 Share Tips – 8 August 2011

5 tech stocks to weather the storm

The Tangled Web of the Australian Housing Bubble

Aust market braces for nervous start

5 Forex Day Trading Mistakes To Avoid

Using Volume To Predict Market Moves

Top ten shorted stocks

US downgraded by S&P

China scolds US on “debt addiction”

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