I checked in with Societe Generale economist Aneta Markowska to see what her interpretation of the market action was. She recently cut her real-time Q1 U.S. GDP estimate to just 1.25% due to weakness in retail sales, business inventories and the international trade balance. Here are her comments to me concerning the credit outlook downgrade, reprinted verbatim:

"It shouldn't impact the near-term economic outlook, unless risky assets really fall apart here. Interestingly, the bond market really took the S&P in stride, so that limits the near-term economic impact. We still look for a more respectable GDP reading in Q2 (~4%), which would be more in-line with the ISM surveys and production data.

"The potential impact of S&P's decision is medium-term. I think that the outlook change could serve as a wake-up call in Washington and increase the chances that a compromise can actually be reached this year. If so, the fiscal drag on the economy in 2012-2013 would be greater than we had assumed, and the Fed's exit could be delayed. Ironically, this means that the S&P move could actually prove supportive for the Treasury market in the medium-term."

So there you have it. A credit outlook downgrade of U.S. government debt -- on concerns we won't repay it -- in the end had a positive influence on bond prices as traders priced in the economic impact of fiscal tightening.

In simpler terms: Wall Street is betting on a new recession caused by the budget cutting and tax hikes as we deal with our debt.

Pricing in the pain

So how painful will austerity be?

Well, the cuts and tax increases currently proposed by the president and House Republicans don't come close to controlling the problem. The International Monetary Fund -- a global watchdog on fiscal matters -- has lambasted U.S. leaders for the lack of a "credible strategy" to reduce debt.

According to IMF calculations, no more than half the spending cuts and tax increases that are needed to reduce the government's debt to pre-financial crisis levels (around 60% of GDP) by 2030 have been proposed. House Budget Committee Chairman Paul Ryan, R-Wis., wants $6 trillion in cuts over 10 years; the president wants $4 trillion in savings over 12 years.

The IMF estimates that -- after accounting for age-related spending on entitlements -- the federal budget would need to be slashed by nearly $12 trillion by 2020 to reach pre-crisis levels.

Compare that number with the much-ballyhooed $38 billion "cut" from the 2011 budget agreement hammered out two weeks ago to avoid a government shutdown. This was voodoo austerity. The Congressional Budget Office estimates that actual reductions in spending amount to only $352 million, or 0.002% of GDP.

All of that heavy breathing and political posturing, and we haven't even started yet.

And one could argue that politicians are just doing what Americans want. People like the idea of a balanced budget and reduced indebtedness, but they don't like what we'd have to do to get there. In a recent USA Today/Gallup Poll, 47% of respondents said we should not make significant cuts in spending in next year's budget.

It's hard to find much support for specific actions, either. A Pew Research Center poll found that ideas including reducing funding for roads, making Medicare recipients pay more out of pocket, eliminating the home-mortgage-interest-deduction and raising the Social Security retirement age were all nonstarters. The only two ideas that attracted a majority of respondents were raising the Social Security contribution cap (a variation of tax the rich) and freezing the salaries of federal workers.

We're also facing these uncomfortable choices at a time of economic vulnerability because of increased inflationary pressure and a drop in consumer confidence.

Standard Chartered economist David Mann told clients this week that the U.S. economy "is proving to be less resilient in the face of shocks than many would have thought." And that's because consumers are still working off the excesses of the housing boom. Incomes are stagnant.

Already, Mann estimates at the GDP growth contribution from consumer spending is down to 1.3% from 2.9% in the fourth quarter. We're nearing the economy's stall speed -- and spending cuts and tax increases won't help.

Time to pull on the reins

Like the market, I think we will eventually do the right thing. But that means we're headed for another soft patch of growth as austerity bites. We had one last summer as the eurozone was forced to clamp down economically and save Greece. Now, it's America's turn.

Because of this tough patch ahead, I've recommended my newsletter clients move into conservative assets like iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and shun risky assets like commodities and economically sensitive cyclical stocks for now.

One point of concern has been the huge shift into late-stage defensive stocks like consumer staples and health care over the past two months -- ending three years of relative underperformance. Similar behavior was seen in late 2007 as the last bull market entered its final stage. Investors are hunkering down.

The trouble with diving headfirst into defensive issues, though, is that they tend to outperform early in this cycle. So be careful not to buy a price spike.

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If you are a buy-and-hold investor holding a varied portfolio, then than you should already be prepared for this movement, called sector rotation. If you like to actively manage your holdings, move away from cyclical and small-cap stocks. Hold more in cash until investors show an appetite for risk again.

And although precious metals look pricey now, I'd increase exposure to gold and silver assets -- specifically the commodity ETFs like the SPDR Gold Shares (GLD, news) and the iShares Silver Trust (SLV) -- as protection against the Federal Reserve's temptation to increase inflation as a way of easing the government's debt burden. Be sure to see my April 18 column for more on the long-term outlook for gold prices.

Disclosure: Anthony has recommended iShares iBoxx $ Investment Grade Corporate Bond to his newsletter subscribers.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.