The financial market was surprised when Fitch decided to downgrade the US credit rating from the coveted AAA to AA+. S&P previously downgraded the US long-term credit rating back in 2011. What caused Fitch to downgrade the US credit rating? And what does it mean for investors?
Is the Downgrade Warranted?
Fitch mentioned many reasons for the downgrade, and let’s look at some of the major ones here to see if the US indeed deserves the downgrade.
Rising US Government Debt
This issue probably doesn’t surprise you. US debt is growing rapidly as the federal government issues more to cover its yearly budget deficit.
Before the 2008 great financial crisis, the US debt-to-GDP ratio was only around 50-60%. After the crisis, the ratio jumped to more than 100%. The debt-to-GDP ratio increased further during the COVID era as the government expanded its debt significantly to tackle the pandemic. It has since declined a bit but has not reached the pre-pandemic level. The US debt-to-GDP ratio of around 120% is way higher than the average peer nations with similar AAA credit ratings. The other AAA-rated countries have a median ratio of about 39.3%, while AA-rated nations have a median ratio of 44.7%.
It is hard to argue that the US long-term debt situation has deteriorated slightly. Although there are other countries with higher debt-to-GDP ratios, such as Japan, with a ratio of more than 200%, the current level of 120% is relatively high historically. With a relatively high ratio and the trend of increasing debt, it makes sense for Fitch to take this consideration strongly for the downgrade.
US Government Budget Deficit
Again, this should not be a surprise for many. The US government has been running a budget deficit every year. The deficit is funded via debt. Fitch expects the budget deficit to widen to 6.3% of GDP in 2023, up from 3.7% in 2022. Fitch further expects the deficit to widen to 6.6% in 2024 and 6.9% in 2025. As the deficit gets wider, the debt will rise faster, and the interest payment will also increase. This debt cycle can be dangerous if spiraling out of control.
The US interest payment from its debt is projected to hit $1 trillion a year pretty soon.
Once again, Fitch appears to have a legitimate reason for this downgrade. Unless the US government can control its spending or grow its economy much faster than its debt, there is a basis for questioning its long-term debt prospect.
Erosion of Governance
In Fitch’s view, there has been a degradation of the US governance in the past 20 years. The debt ceiling has been a point of contention in Congress for the past decade. Every time the ceiling is reached, we will likely see a standoff between Republicans and Democrats. These last-minute internal affairs may erode the confidence in how the US government handles its fiscal management. And most recently, the bipartisan agreement reached in the last debt ceiling standoff resulted in the suspension of the debt ceiling until January 2025. Instead of trying to cut the spending, the deal removed the ceiling altogether, assuming the federal government would maintain its current spending rate.
Fitch cited even more reasons, such as the possible upcoming recession in the US, which may widen the budget deficit further, and various other reasons. Regardless, Fitch seems to have a legitimate basis for downgrading the US credit rating. What do you think?
What Does It Mean For Investors?
Sure, the downgrade seems to be warranted. The current US fiscal policy is leading to a worsening of the US long-term debt situation. What does this mean for investors? In short, probably not much for now. Business as usual.
Investment Grade Status
Despite being downgraded to AA+, the US credit rating is still considered investment grade. There is little difference in terms of eligibility for institutional investors in investing in the US debt. Most institutional and pension funds will still be able to invest as usual. The difference between AAA and AA+ is primarily psychological.
The bond market appeared to be unfazed by the downgrade. This is not the first time anyway, because S&P already downgraded US debt a decade ago. It wouldn’t be a surprise if Moody’s eventually follows suit and downgrades at some point.
Still the Most Liquid Bond Market
Well, the US still has one of the most liquid bond markets in the world. Where else would the big institutional or pension funds go if excluding the US?
The other countries still holding the coveted AAA rating are dominated mainly by European countries, Australia, and Singapore. They, unfortunately, cannot provide the depth and liquidity offered by the US bond market.
Further Downgrade Implication
If the US continues its current fiscal policy, these rating agencies may further downgrade the US credit rating in the future. What will happen in that scenario?
The US government will likely need to pay higher interest to borrow as the lower rating implies higher risks. US consumers will be impacted as their borrowing costs, such as mortgages and car loans, may rise. Unfortunately, this higher borrowing cost will lower their purchasing power. Companies are also likely to be affected because their borrowing costs will increase as the yield on US government bonds, considered safe investments, increases. Profitable companies may not be affected too much, but those with high debt may need to refinance at a much higher rate. As a result, this will reduce their profitability. Generally, it will be more costly to rely on debt to grow the economy.
In the future, if the US debt is downgraded below the investment grade level, a major shift in financial power may occur as most institutional money can no longer access the US bond market. Nevertheless, there is no need to contemplate this situation at this time.
Why the Sell-off in Equities
Upon the Fitch downgrade, we saw the equities market selling off. In our opinion, the stock market was already overbought after a massive run-up since the start of the year. The market was simply waiting for a reason to sell off. This is a healthy correction to prevent the market from overheating.
What do you think of this Fitch US credit rating downgrade?
