What a difference one day makes. A day after helping spur a big rally on news of benevolent billionaire Kirk Kerkorian's tender offer,

General Motors

(GM) - Get Report

exerted a negative toll on stocks Thursday.

Standard & Poor's, unconvinced by GM's plans to address its shrinking market share, rising benefit costs and staggering $375 billion in debt, cut the automaker's debt rating to junk. S&P also lowered

Ford's

(F) - Get Report

debt to speculative grade status.

While the GM downgrade was widely expected, the timing, coming after Kerkorian's offer to raise his 3.9% stake in GM by another 5%, surprised the markets. Ford's downgrade was as an even bigger surprise.

Maybe Kerkorian took the opportunity to cash in some of the 18% gains his shares saw Wednesday, thanks to his offer. However, those shorting GM's stock in anticipation of the junk status move must have had a not-so-fun ride over the past two days.

GM shares fell 6%, dragging the

Dow Jones Industrial Average

, which traded above 10,400 prior to the S&P announcement around 1 p.m. EDT, down 44.26 points, or 0.43%, to 10,340. The

S&P 500

, weighed down by a 4.5% decline in Ford shares, fell 3.02 points, or 0.3%, to 1172.63. Weakness in auto parts suppliers

Visteon

(VC) - Get Report

, down 5%, and

Delphi Automotive

( DPH), down 7.2%, also weighed on the index.

The Nasdaq didn't totally avoid the downward trend, but emerged relatively unscathed, falling 0.43 points, or 0.02%, to 1961.80.

The downgrade of GM, the largest issuer of corporate debt in the U.S., can't be good news for owners of long-term corporate debt.

GM's bonds took a major hit. Many portfolio managers are barred from holding below investment-grade debt and will now be forced to unload GM securities. And in light of the S&P downgrade, Kerkorian's offer seemed to provide little hope for other debt holders. GM and Ford were the most actively traded corporate bonds Thursday, with GM bonds maturing in 2033 widening an additional 68 basis points over Treasuries with similar maturities vs. the prior day's spread, according to Miller Tabak.

According to John Atkins, corporate debt strategist at IDEAGlobal, Kerkorian's investments did little for GM bondholders in the first place. The billionaire's increased stake, on the contrary, raised risks that Kerkorian would gather shareholder support to obtain more shareholder return instead of paying its debts.

Overall, the downgrade keeps intact the possibility of huge corporate defaults in investors' minds and is likely to further widen corporate spreads to reflect the perceived increase in risk.

This was already in play on Thursday, as the GM news also spurred a flight to quality into Treasury bonds, possibly putting a lot of investors into embarrassingly long positions ahead of the key April employment report on Friday.

The benchmark 10-year bond finished up 8/32, its yield falling to 4.15%, its lowest level since mid-February.

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The Big Test

While the GM downgrade will likely make it harder for other firms to obtain cheap credit, overall credit access may hinge on Friday's much awaited April employment report. Crucially, the debt market now has to factor in rising inflation pressures, and employment costs typically represent 70% of these pressures.

Economists on average expect the economy to have added 175,000 jobs in April, up from 110,000 in March. The unemployment rate is expected to remain at 5.2%. But there are risks to these forecasts.

Lehman Brothers senior economist Ethan Harris notes that the average forecast error on payrolls is of about 100,000. "That's a little scary, but the fact is there's no magic way to predict payrolls," he says.

The most reliable indicator for economists is the four-week average of jobless claims, which currently stands at about 321,000, which points to a 200,000 gain in payrolls. But jobless claims reveal more about unemployment than they do about job growth. And other indicators, such as the April ISM surveys, point to a weaker job picture. That's why Harris roughly expects payrolls to grow by 170,000.

That number, or any number above 150,000, is still consistent with Harris' expectations that the

Fed

will keep hiking rates to 3.75% this year. Payroll growth of 125,000 or less, both in April and in May, could presumably induce the Fed to halt its tightening campaign at its next rate-setting meeting at the end of June, Harris says.

But clearly, the Fed is not taking its cues on inflation from unimpressive job growth, nor from wages, which have remained equally tepid. Rather, it's closely watching inflationary pressures stemming from employment costs, which have continued to rise amid soaring health care costs and energy prices.

First-quarter productivity figures, released on Thursday, showed that businesses continued to produce more without hiring more. Higher health care and energy costs, however, saw compensation costs rise at a 5% annual rate during the first quarter. Productivity, however, is expected to continue slowing during the coming year, which means that employment and wages could rise.

"The slowdown in productivity and uptick in unit labor costs will result in higher core inflation in 2005," says Wachovia senior economist Mark Vitner, adding that the Fed, which pays a lot of attention to the productivity data, will raise rates more than the market currently expects.

Sector Strategies

Friday's employment also represents a big test for the stock market. Slower-growth scenarios have prompted investors to readjust their portfolios, shedding cyclical stocks and moving into defensive issues such as utilities, health care and consumer staples.

But employment is expected to have rebounded somewhat from April's disappointment. With the economy still growing at 3.1% in the first quarter and expected to average 3% growth quarterly for the balance of the year, does it mean that cyclicals should make a comeback?

It depends which cyclicals, answers Sanford Bernstein market strategist Vadim Zlotnikov. If April payrolls were to come in way above expectations, say at 250,000, the market likely would buy into the "recovery story" and buy recently battered cyclicals.

"But I would sell them all," says Zlotnikov. "Basically, we remain in an environment of decelerating earnings."

With 250,000 payrolls, job growth would further fuel inflationary concerns at the Fed and encourage a longer period of sustained rate hikes.

At 200,000 payrolls or less, Zloktnikov would keep his cyclical holdings, which are industrial and tech-based, i.e. not linked to consumer spending, including

Nokia

(NOK) - Get Report

EMC

(EMC)

and

Waste Management

( WMI).

Growth, he says, will resume but it will be strictly on the corporate spending side of the economy, not on the consumer side. Sanford Bernstein does not do investment banking.

To view Aaron Task's take on today's market,

click here.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.