Fitch downgrades the US by one notch

Good morning all…

I woke up to the news of the Fitch downgrade (I’m 8 hours away from ET) and it’s all anyone can talk about. I appeared on Bloomberg to talk about it briefly but, that was just on the headlines and looking at the markets.

What happened - the Fitch down graded the long-term Country Issuer rating from AAA to AA+. That’s one notch below the highest rating. The outlook remains Stable.1

As a reminder, S&P Global downgraded the US in 2011 to AA+2. Moody’s is the only one now who maintains the highest rating for the US at Aaa.

The bottom line is the same for when S&P downgraded the US - the cotinuous postponement of the debt ceiling and the level of debt. Although Fitch can make a better case for since US debt has ballooned far more since 2011.

Having read the full Fitch report now, here are some highlights: 

• Governance is an issue - the US has a complicated budgeting process and there’s been a deterioration in standards of governance over the last 20 years.

• Postponing the Debt Ceiling has become an issue of constant worry because of the political standoff’s

• Tax cut and Fiscal Stimulus has let to excessive debt with limited progress on rising social security and Medicare costs with an aging population. The CBO projects that the Social Security fund will be depleted by 2033 and the Hospital Insurance Trust Fund (used to pay for benefits under Medicare Part A) will be depleted by 2035 under current laws, posing additional challenges for the fiscal trajectory unless timely corrective measures are implemented.

• This will cause the government deficit to rise to 6.3% of GDP in 2023, from 3.7% in 2022. Fitch forecasts a deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025

• Debt-to-Nominal GDP is expected to increase to 118.4% by 2025. It is currently at 112.9%, according to Fitch. I’m not sure how Fitch calculates this but, we have the levels from the Fed that show us that the US is already there.

• The interest-to-revenue ratio is expected to reach 10% by 2025 (compared to 2.8% for the 'AA' median and 1% for the 'AAA' median) - Interest costs are bound to increase because of the increase in debt levels and the higher rates.

• Fitch projects a mild recession in Q4, 2023 and Q1, 2024.

While the debt metrics are far above that of even AA+ rating, Fitch still considers the US to have a dynamic business environment and well-diversified, high income economy. The dominant status of the US dollar is also a positive factor.

What are the implications for the market? 

Well, this is certainly not great news. As I said in the interview, this is terrible for risk assets. An increase in debt levels certainly increases the vulnerability of the US to future economic shocks.

The initial reaction was a purchase of the Japanese Yen and other developed market treasuries, to avoid the US.

This is the long-term country “issuer” rating, i.e., it should affect long-term bonds. However, we saw people buying treasuries as a safe haven, and we’re likely to see some strength in the US dollar because of the same effect.

At the end of the day, the US still maintains a rating far above that of most other developed economies, with rates that are now lucrative. There’s also the view that if the US can catch a downgrade, so can other developed markets. Comparatively, the reward still remains in the US.

However, there are funds that need to maintain investments in certain ratings. These will likely have to make adjustments to their portfolios.

There are also companies who receive a higher rating on their debt because of the US Country rating and therefore, better rates. These will also likely be adjusted and rates may increase for the debt.

We are likely to have a rough few days of trading. The market has been resilient thus far but, August is always a tough month anyway. This news will likely create some more pressure and may cause some sell off.

Let’s be nimble!