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What a German Downgrade Could Mean for Investors

While Standard & Poor’s warning that it might downgrade the credit ratings of 15 European countries has further fueled investor concerns about the global markets, it’s the prospect of the once-impervious Germany losing its Triple-A status that has many analysts and advisers most worried.

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The ratings agency announced Tuesday that it was considering downgrading the European Financial Stability Facility, depending on whether and how much it decides to downgrade the six countries that guarantee its funding: Austria, Finland, the Netherlands, Luxembourg, and France and Germany.  Financial advisers and other investment professionals note that a warning doesn’t necessarily lead to a downgrade. And even if it does, the advance notice may mute the ultimate impact of any action by S&P.

Still, advisers say a downgrade of Germany in particular could impact stock, bond, and currency markets around the world. European stock markets would take a big hit, yields on bonds priced based on German bunds would rise, and the euro could be put on even shakier ground. “A downgrade of Greece or Ireland wouldn’t have any market impact,” says Tommy Molloy, the head of trading at FX Solutions. “A downgrade of Italy would start to have an impact. The absolute biggest impact would be the strongest name in Europe which would be Germany.”

Here are some ways investors can tweak their portfolios to prepare for those scenarios:

Bonds. If Germany loses its Triple-A status, investors globally would likely pile into U.S. Treasurys  in search for safe, liquid bonds, investing pros say. That could push yields on Treasury bonds down from their current 2% level, making some higher yielding bonds, such as corporate bonds, more appealing, says Martin Hopkins, a financial adviser in Annapolis, Md. In Europe, investors might initially ditch bunds as they question Germany’s ability to shore up troubled European countries and make good on its own debt, experts say. That would push yields up on bonds from other countries in the region that are priced off of German bunds, says Hopkins. But a positive development would eventually make investors comfortable with returning to bunds, which are the safest  in the Euro zone, and yields would come  back down,  says Kevin Brosious, a financial adviser in Allentown, Penn., who is splitting his bond exposure between U.S. Treasurys and investment grade corporate bonds.

The uncertainty makes it difficult for investors to figure out the next step, with the European debt crisis threatening to drag down the U.S. at a time when the economic news at home otherwise signals slow but steady growth, he adds. “We’re being a lot more short term than we were before,” says Hopkins, who has cut back on flexible bond funds, where managers have the ability to invest across bond sectors, to hold more conservative investment grade bond funds.

Currencies. Out of all the euro-zone countries, Germany is the least likely to be downgraded, which means it’s also the downgrade most likely to impact the market, says Molloy. That news would cause a “knee-jerk reaction” in the currency markets, and the euro would fall, Molloy says. Still, markets are more focused on the European summit on Friday than on any potential action from S&P, he says. “Quite honestly, no one cares what S&P has to say, the market is much more concerned with what Europe has to say on Friday,” he says.

In this volatile and headline-driven environment, risk management is crucial, Molloy adds. “It’s hard to create contingency plans for every eventuality,” but it makes sense to set stops tighter than usual and think carefully about the overall risk in a portfolio as this crisis continues to unfold, he says.

Stocks. European stock markets would certainly take at least a short-term hit from a downgrade of any of the six countries that backstop the EFSF, Kleintop says. “Markets would be led lower by financials,” he says. U.S. stocks, particularly bank stocks, would also fall. Investors worried about this scenario could insulate themselves by cutting back on their exposure to European and U.S. banks, he says. And because the European Central Bank might well react to a downgrade with some kind of stimulus, which would essentially amount to printing money, precious metals could benefit, Kleintop says. To prepare for a potential downgrade of Germany, “you’d probably want to be underweight the banks and overweight precious metals,” he says.

Many U.S. investors have likely already cut back on their exposure to European stocks, but this news does provide yet another reason to make that move, says Frank Nargentino, a registered representative at JHS Capital Advisors. “Nobody knows where the real bottom is in European markets,” Nargentino says. U.S. investors should stay away from the continent until the situation starts to improve, and focus on large-cap dividend-payers here at home, which may take short-term hits from European news but should reward investors over the long term, he says.

Additional reporting by Jonnelle Marte

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