More noise than news: Fitch downgrades US debt rating
What’s been going on?
- Fitch, one of the three main rating agencies, downgraded their US sovereign rating from AAA to AA+.
- Market sentiment was impacted slightly but this was more due to the timing rather than the importance of the news.
- While this change highlights the need for fiscal discipline, this is not surprising to the market. Rather, this is well known to the market, hence the short-lived reaction.
Last week there was a slight downgrade in the United States’ creditworthiness, from AAA, (the highest assessment), to AA+ by Fitch, one of the three main rating agencies along with Standard & Poor's (S&P) and Moody’s. These credit assessments are similar to a credit report that an individual might have, but more publicly available. This comes 12 years after the US downgrade by S&P, from AAA to AA+. Only Moody’s, the final of the big three, still gives the US the highest rating of AAA.
The key concerns cited by Fitch* are well known. Firstly, the decline in US governance standards and the continued high level of bipartisanism and polarisation. Equally, there have been few steps to address the demographic issues that will necessitate greater government spending such as social security costs. Secondly, there has also been an increase in the fiscal deficit (i.e. shortfall of tax revenues compared to government expenditure), which must be closed by government borrowing.
It is also worth noting that while the US benefits from being the de facto reserve currency of the world, there are structural changes on the horizon, such as the so-called BRICS countries (Brazil, Russia, India,China, and South Africa) discussing settling their trade in their domestic currencies rather than using the US Dollar (USD). Globally most currencies are priced in USD on financial markets and global Foreign Exchange (FX) reserves are still dominated by the Dollar at 59.0%, with the Euro a distant second at 19.8%.**
However, the move came as a surprise to many market participants and commentators since recent data has largely shown the US economy looks stronger than previously forecast.
What does this mean for investors?
The news caused a knee-jerk negative reaction, which weighed slightly on equity markets. However, for us and many in the market, this is not wholly unexpected.
This also needs to be viewed in context as there are currently only two companies, Johnson & Johnson and Microsoft, which hold the AAA rating from all three rating agencies in the S&P500 index. While Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore, and Australia all hold triple-A ratings from the three main rating agencies, none of them benefit from being the issuer of the world’s reserve currency.
Additionally, most investors will prefer to hold US over Italian bonds, because they offer similar yields despite the US being significantly better rated than the BBB marking that Italy currently holds.***
Cadro's house view
This decision comes at a surprising time, in the summer holiday period for the Northern Hemisphere which is typically quieter. But ultimately this change doesn’t add any new information to the discussion.
US treasuries continue to form a crucial part of a diversified global portfolio. This is especially true when there is an increase in investor concern, which typically sees both treasuries and the US Dollar gain - forming an attractive hedge for equity investors.
The accepted and exceptional role Treasury bonds play in global financial markets means that investor behaviour is unlikely to be driven by this latest rating assessment.
Ultimately, the US will remain the global backbone of the financial system until there is a real alternative. This does not change the fact that the US faces some tough choices, especially since the Debt Ceiling will need to be raised again in early 2025, but for now investors are far more focused on the trajectories for growth, inflation, and interest rates.
References
(*) https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023
(**) https://data.imf.org/?sk=e6a5f467-c14b-4aa8-9f6d-5a09ec4e62a4
