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Investors put to test as U.S. debt drama intensifies

July 24, 2011 | 10:25 pm

Treasury Will U.S. investors run and hide Monday, reacting to Washington's inability over the weekend to reach a deal slashing the federal budget deficit?

The argument against a major stock market sell-off is that things are unfolding pretty much as Wall Street figured they would: Congress and the White House would bicker right up to the brink, meaning to the Treasury’s Aug. 2 deadline for lifting the government’s $14.3-trillion debt ceiling.

Still, anything that poses a further risk to the weak U.S. economy could drive more equity investors toward the exits.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, worries that the impasse in Washington could cause another major shock to the financial system.

“If we got to a crush point where we couldn’t come to a deal, that would wipe out the financial sector,” Baker said. Lending could halt among banks as they hunker down, uncertain of the struggling economy’s next turn.

But shares of banks and other financial companies already are the worst-performing stocks on Wall Street this year. And the financial sector got a lift last week -- despite the debt-talks impasse -- amid better-than-expected second-quarter earnings reports from key players including Wells Fargo & Co., Morgan Stanley and SunTrust Banks.

Earnings reports in general have been keeping many investors in the market, as blue-chip companies once again beat analysts’ expectations. Of 345 major U.S. companies that had reported results through Friday, 70% topped analysts’ consensus estimates, according to data-cruncher Bespoke Investment Group.

Although that percentage should tail off as reporting season progresses, it’s a strong start, Bespoke said. “As it stands now, fears of a weak earnings season have been put to rest,” the firm said in a weekend report.

Indeed, earnings have lit a fire under some stocks in recent weeks, notably Google Inc., IBM Corp., Coca-Cola Inc., McDonald’s Corp. and Harley-Davidson Inc. But the market’s strength also means that key indexes remain close to the multiyear highs reached in spring -- which could give investors who are fearful of Washington’s debt drama an excuse to take some money off the table.

Dow722 The Dow Jones industrial average (charted at right) closed Friday at 12,681.16. The Dow is up 9.5% year to date and just 1% below its 2011 high of 12,810 reached April 29.

The broader Standard & Poor’s 500 index is up 7% year to date and 1.4% below its high also reached April 29.

Some large investors said the greatest risk to markets in the short term was that major credit-rating firms could downgrade the nation’s AAA rating, even if Washington reaches a stop-gap measure on the debt ceiling by Aug. 2 to avert potential default on Treasury bonds.

“The risk of losing our AAA rating has increased significantly,” said Mohamed El-Erian, head of money management giant Pimco in Newport Beach.

The two best-known credit-rating firms, Standard & Poor’s and Moody’s Investors Service, have warned in recent weeks that the U.S. rating was in jeopardy because of Washington’s inability to reach an agreement on spending.

S&P on July 14 said it could drop the U.S. rating from AAA if Congress and the White House fail to achieve a “credible” plan to slash the federal deficit.

Having made the threat, “That’s going to put S&P on the spot” this week, El-Erian said.

A ratings cut could be horrendous for America’s global image, and also could leave more investors feeling as if they should just throw up their hands.

What should they prefer at that point: downgraded Treasury securities, U.S. stocks near bull-market highs, gold at all-time highs, or cash accounts that pay near zero?

-- Tom Petruno and Duke Helfand

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Photo: The Treasury building in Washington. Credit: Andrew Harrer / Bloomberg News

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