(August 10, 2011) — Consulting firm Towers Watson says the S&P’s downgrading of the US long-term credit rating reflects a fragility in the global economy.

“The events of the past several days are consistent with the outlook we had prior to these global events — that we expect a bumpy path to recovery, including higher risk than average for all asset classes, with pressures from the debt overhang materializing in places that are hard to predict,” Carl Hess, Towers Watson’s global head of investment, notes in a statement.

The consulting firm expects market volatility to continue for years. In its report, it examines the following three recent events, analyzing their impacts on global markets.

Event 1: Fear of a US recession and a sharp slowdown in global growth. According to Towers Watson, the world economy, especially in the overindebted developed countries, remains relatively fragile.

Event 2: US sovereign downgrade. Towers Watson anticipates more selling of equities in the next few days, but not of bonds. It also expects a modest increase in US borrowing costs and for foreign investors to diversify away from US dollar assets. “Our near-term base case is that Treasuries are unlikely to be significantly impacted, with Treasury markets largely driven by the economic outlook, as was the case in Japan following the loss of its AAA rating and demand from risk-averse investors,” says Hess in the statement. “We do not anticipate much forced selling from any significant investor base, although there is a tail risk that some unrecognized financial system linkages may cause large-scale disruption.”

Event 3: Euro-zone crisis. The consultancy noted that it is imperative that a broad and sufficient package of policy measures is implemented to address a potential contagion.

Despite all of the market volatility of the past few days, pension funds are urged to stay calm and maintain a long-term view.

“I think there’s a short-term and a long-term realization for institutional investors,” Michael Dunn, Chief Research Officer of TruColor Capital Management, told aiCIO. “Short-term, there’s panic and an instinctive flight to risk-aversion…Once you get past the shorter-term risks, institutions need to focus on how they’re going to fund their liabilities in an environment where interest rates will stay low in the foreseeable future,” said Dunn, noting that investors have few alternatives to the returns of equity investing. “Institutions that have cut back on equities will soon have very little choice but to go back to equities because those returns won’t come from any other asset class, so it may be that institutions will be more receptive to new, alternative ways to get that equity exposure,” he added.