US downgrade hits world stocks as investors flee

NEW YORK - The fallout from Standard & Poor's downgrade of the United States pushed world stocks to their lowest level in nearly a year on Monday and drove investors to the safety of gold and bonds.

Strange as it may be, investors sought shelter in the asset that was downgraded -- choosing U.S. government bonds for their liquidity and perceived high quality.

Investors shunned stocks and commodities, struggling to discern the effects of the downgrade, which could hit various components of the financial sector, from mortgage lenders to municipal issuers and insurers.

"Markets know the U.S. government will make its payments, but the credit rating downgrade and the continuing fiscal contagion pressures in Europe reinforce market fears of a renewed period of financial turmoil and the possibility of economic contraction," Craig Alexander, chief economist at TD Bank Group, wrote in a note.

U.S. stocks lost as much as 4 percent by early afternoon and European stocks hit a two-year low. Wall Street's favored gauge of investor anxiety briefly spiked above 40, a sign investors are afraid of more declines to come. The CBOE Volatility Index was up 21.8 percent at 38.98.

MSCI's all-country world stock index dropped 3.8 percent. The index was at its lowest level since September 2010. The sell-off since July 29 has wiped $3.4 trillion off the value of global stocks, the equivalent of Germany's gross domestic product.

The sell-off crowded out any relief from news that the European Central Bank was buying Italian and Spanish government bonds in the latest move to staunch the euro zone debt crisis.

The downgrade -- and the threats of subsequent moves by S&P or the other ratings agencies -- raise uncertainty as to the credibility of the United States in the global economy as investors increasingly worry about another recession.

Central to S&P's argument was that the political paralysis in Washington has reached a point where the government would be unable to deal with worsening deficits and sagging economic growth. This burdens a stock market already skittish after last week's outbreak of fear.

"In many ways this is not about the downgrade. I think it's about the underlying fundamentals and issues that are embodied in the downgrade itself," said Jonathan Golub, chief U.S. equity strategist at UBS in New York.

"Now the market is really focusing on long-term sustainable growth issues and that is why you have the market taking it on the chin."

SEARCH FOR SAFETY

Several major brokerages have in recent days lowered their expectations for economic growth and share appreciation for 2011 and 2012.

Moody's repeated a warning that it could downgrade the United States before 2013 if the fiscal or economic outlook weakened significantly. But it said it saw the potential for a new deal in Washington to cut the budget deficit before then.

Investors looking for a safe place to park their money pushed gold to a record high above $1,700 an ounce. The dollar dropped against the Swiss franc and yen, while the euro fell.

The euro hit a record low against the Swiss franc, falling as low as 1.0640 Swiss francs. It also lost 1.8 percent versus the yen.

The dollar fell 1 percent to 77.57 yen and was down 2.1 percent at 0.7507 Swiss francs.

The 30-year bond was last trading up 3-4/32 points in price and yielding 3.69 percent, down from Friday's close at 3.85 percent. The 10-year Treasury note was last up 1-26/32 in price and yielding 2.36 percent, down from 2.57 percent late on Friday.

European shares closed down 4 percent after earlier registering gains on the ECB action.

The Dow Jones industrial average dropped 378.69 points, or 3.31 percent, at 11,065.92. The Standard & Poor's 500 Index was down 51.55 points, or 4.30 percent, at 1,147.83. The Nasdaq Composite Index was down 111.99 points, or 4.42 percent, at 2,420.42.

There have been 26 other days since 2000 when the market has been down more than 3 percent at noon, according to Birinyi Associates Inc. On average, 85 percent of the time the market continues lower until the close for a further 1 percent decline.

The following day the market was up 70 percent of the time for a gain of 1.2 percent, Birinyi wrote.

- Reuters