Investment Strategy Brief:
Fitch Demotes U.S. Debt

Below is a transcript of this week’s video.

Hi, this is Jason Pride, Chief of Investment Strategy and Research at Glenmede.  

Last week, Fitch Ratings Inc., one of the three nationally recognized debt rating organizations, downgraded U.S. government debt from the highest rating (AAA) to AA+. So, why did fitch do this now and what are the implications for the economy and markets?

Well, a quick survey of the landscape of sovereign debt across the globe, as shown through this country choropleth, and one will quickly realize that there is a full range of rating from AAA at the top down to countries in difficulty with C and D ratings. A county does not get assigned a AAA rating just for looking smart or being big. There are standards, and a AAA rating is meant to imply near perfection – a near-zero risk of loss – and should likely be reserved for countries where there are no questions or concerns.

According to Fitch, the decision to downgrade U.S. government debt was a result of the expectation of further fiscal deterioration, an increasing debt burden, and the erosion of governance. These sound like some serious concerns. Let’s look at each in turn.

The rating agency specifically cited the lack of resolve of both political parties in reining in the budget deficit. The result of this is the current primary spending deficit of near 3% of GDP, which has driven an accumulation of debt, on which the government must also pay a growing amount of interest. It is expected that this dynamic will compound into a bigger problem over time if efforts are not made to contain the spending.

Due to the rapid rise in the cost of borrowing and the pace of new treasury issuance, debt servicing costs are rising as a % of the government budget for the first time in 35 years, and are expected to get close to 15% of the government’s budget within the next two years. At similar levels in the 1980’s, the U.S. government responded with a series of bills to contain spending. If that does not occur, as projected, that debt burden will even rise higher.

The rating agency also cited the recurring periods of debt ceiling brinkmanship. Here we show credit default swap pricing on U.S. Treasuries over the last 15 years. The occasional spikes are those instances that Fitch is pointing to, with the latest one being the largest.

Interestingly, the decision comes over a decade after Standard & Poor’s 2011 downgrade, which occurred after an equally polarizing debt ceiling debate. Like in 2011, equity markets have experienced some volatility with the announcement, which probably should be expected. However, since the downgrade did not unveil any incremental fiscal information and the U.S., still with a AA+ rating from Fitch, will remain a large high quality borrower, the overall direct market impact will likely be minimal. Further, Fitch placed its outlook for U.S. debt as neutral after the downgrade, suggesting that the prospect of further government debt downgrades are unlikely.

As a result, we are skeptical that Fitch’s downgrade will, by itself, drive market volatility beyond a few days, but it does highlight longer-term risks associated with excessive government spending and the political dysfunction that surrounds the way the U.S. government is debating and resolving its budgetary differences. In short, longer-term, something needs to change.

 So to summarize:
•    Fitch downgraded the U.S. government’s debt from AAA to AA+, citing financial deterioration, a rising debt burden and governance 
•    Some may question the timeliness of the announcement, but it is reasonable to argue that the U.S. may no longer deserve a “perfect” AAA rating
•    Some market volatility around the announcement is understandable, but the downgrade by itself is unlikely to drive the market for long
•    Whether AAA or AA+, the U.S. remains one of the highest quality issuers among its peers, justifying ongoing demand by investors
•    Perhaps more important, Fitch’s downgrade highlights longer-term risks from the U.S.’s lack of budgetary discipline and political dysfunction.

Thanks for listening! And please don’t hesitate to reach out with any questions.

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